CRE FINANCE W RLD

CRE Finance Council

Summer 2017
Volume 19 No. 2

The Voice of Commercial Real Estate Finance

A publication of

EVOLUTION
CHANGE
DISRUPTION
CREFC
MIAMI
2O18
CRE FinanCE CounCil JanuaRy ConFEREnCE

JANUARY 810, 2018

loEWS MiaMi BEaCH HotEl, MiaMi, FloRiDa
SAVE
THE
DATE
CRE Finance World Summer 2017 Volume 19 No. 2

Inside this issue...

Retail Store Closing Fiction
Joseph Ori
Paramount Capital Corporation

EVOLUTION page 30
Executive Director Letter
Lisa Pendergast CHANGE
DISRUPTION
CRE Finance Council

page 3
Market Disruptors
Are Here to Stay! A Sherpa for CMBS Borrowers
Abeer Ghazaleh The Value Proposition of
PGIM Real Estate Finance Debt-Resolution Advisors
Editors Page page 12 Michael Gutierrez
Morningstar
Krystyna Blakeslee
Dechert
Secular Trends Transforming page 32
page 4 the CRE Landscape
A Rising Tide Lifts All LIBOR Loans,
Larry Kay
Eric Thompson The Case for Investing in
Kroll Bond Rating Agency Floating-Rate CMBS Now
page 16 Edward Shugrue
Talmadge

Foggy Outlook for Legislative, Non-Bank Lending in an page 36

Regulatory Relief Era of Bank Deregulation
Paul Fiorilla Jan B. Brzeski
CMBS Conduit Q1 2017 Update:
Yardi Matrix Arixia Capital Advisors Retail Exposure Declined While Full
Term IOs and Office Concentrations
page 5 page 21 Rose Sharply
James C. Digney
James M. Manzi
S&P Global

page 39
Hurry Up and Wait! Evaluating Alternative Lending Cross Boarder Capital:
Banks Continue to Impliment Basel IV, Platforms and Their Prospects A Rear View Mirror Only
Though Timing of Final Rules Going Forward Lets You Drive Backward
Still Unclear Gary Bechtel
Jim Costello
Money360
Christina Zausner RC Analytics
CRE Finance Council
page 23 page 41
page 8
A Case for A.I. in CMBS
Dr. Vince Gerbasi
David Nabwangu
AI-Spark

page 26 The Clock is Ticking

The Big Picture: CREFC
Legislative & Regulatory Update for Commercial Real Estate
Ken Riggs
David McCarthy Situs
CRE Finance Council

page 10 page 45
CRE Finance World Summer 2017
1
 CRE Finance Council Officers
Mark Zytko
Chairman , Mesa West Capital CRE FINANCE W
The Voice of Commercial Real Estate Finance
RLD

Gregory Michaud
Immediate Past Chairman, Voya Investment Management
Publisher: Joseph Philip Forte, Esq.
Richard Jones
Vice Chairman, Dechart LLP Editor-in-Chief: Paul Fiorilla
Jack Cohen Co-Managing Editors: Victor Calanog &
Secretary, Darkknight Ventures, LLC Krystyna Blakeslee
Daniel Bober
Treasurer, Wells Fargo Publication Manager: David McCarthy,
CRE Finance Council
Nik Chillar
Membership Committee Chair, Belgravia Capital Management Design: D. Bruce Zahor
Robert Brennan Production: Kristin Searing
Long Range Planning & Investment Committee Chair
Kim Diamond CRE Finance Council Staff
Program Committee Chair
Lisa A. Pendergast
Brian Olasov Executive Director
Policy Committee Chair, Carlton Fields
Michael Flood
Timothy Gallagher Deputy Executive Director
Executive Committee Member, Prima Capital Advisors LLC
Ed DeAngelo
Samir Lakhani Senior Director, Chief Operating Officer
Executive Committee Member, BlackRock
Sara Elkas
Paul Vanderslice Senior Manager, Education
Executive Committee Member, Citi
Nina Fazenbaker
Senior Manager, Programming

CRE Finance Council Editorial Board and Roster Davine Henry

Manager, Accountant Clerk
Paul Fiorilla
Editor-in-Chief, Yardi Matrix Elizabeth Janicki
Manager, Meetings & Events
Joseph Philip Forte, Esq
Publisher, Kelley Drye & Warren, LLP Isabelle Marques
Analyst, Executive Assistant
Krystyna Blakeslee
Co-Managing Editor, Dechert LLP David McCarthy
Director, Policy & Government Relations
Dr. Victor Calanog
Co-Managing Editor, Reis, Inc. Kimberly Pang
Analyst, Programming
Patricia Bach
Genworth Financial Meghan Roberts
Manager, Sponsorship & Marketing
Jeffrey Berenbaum
Citi Martin Schuh
Stacey M. Berger Senior Director, Head of Government Relations
PNC Real Estate/Midland Loan Services Christina Zausner
David Brickman Senior Director, Head of Industry & Policy Analysis
Freddie Mac
Sam Chandan, Ph.D. CRE Finance Council Europe
NYU SPS Schack Institute
Peter Cosmetatos
James Manzi CEO, Europe
S&P Global Ratings
Carol Wilkie
Jack Mullen Managing Director, Europe
Summer Street Advisors, LLC
David Nabwangu
AI - Spark
Brian Olasov CRE Finance World is published by
Carlton Fields
Lisa Pendergast
CRE Finance Council
Stephanie Petosa
Fitch Ratings Volume 19, Number 2, Summer 2017
Caroline Platt CRE Finance World is published by the
Commercial Real Estate Finance Council (CREFC ),
Steven Romasko
Nomura Securities International, Inc. 28 West 44th Street, Suite 815, New York, NY 10036
email: info@crefc.org, website: www.crefc.org.
Stewart Rubin 2017 CREFC - Commercial Real Estate Finance Council,
New York Life Real Estate Investors
all rights reserved.
Peter Rubinstein
Daniel B. Rubock This publication is provided by CREFC for general information
Moodys Investors Service, Inc. purposes only. CREFC does not intend for this publication to be a
Clay Sublett solicitation related to any particular company, nor does it intend to
provide investment advice to investors. Nothing herein should be construed
Eric B. Thompson
Kroll Bond Rating Agency, Inc. to be an endorsement by CREFC of any specific company or its products.
We advise you to confer with your securities counsel to determine
Harris Trifon
Western Asset Management whether your distribution of this publication will subject your company
to any securities laws.
Darrell Wheeler
S&P Global Ratings CRE Finance World assumes no responsibility for the loss or damage
of unsolicited manuscripts or graphics. We welcome articles of interest
David McCarthy
CRE Finance Council to readers of this magazine. Opinions expressed are those of the author(s)
and not necessarily those of CREFC.

CRE Finance World Summer 2017

2
CRE Finance World
Executive Director Letter
Welcome to the
June Edition of
CRE Finance World
The Editorial Team of CRE Finance World (CREFW ), led
by Publisher Joseph Forte and Editor-in-Chief Paul Fiorilla,
never fail to disappoint. They have a knack for gathering
timely and on-point articles that speak to the current state of
CRE finance and property fundamentals. We are extremely
grateful to the CREFW Editorial Board and all of those
authors who give of their time, knowledge, and experience
to make the CREFC magazine one of the best around.
Each one of us face the beat-the-clock work day day
in and day out. In focusing on the demands of today, its
easy to lose the forest for the trees and miss tomorrows
opportunity CRE Finance World allows our members the
ability to look-up and take measure of evolution and change
and what they mean for our businesses going forward.
The latest edition of CREFW is aptly titled Evolution
Change Disruption, and it couldnt be timelier. Evolution
and change are everywhere in our industry urban migration
and an aging population, autonomous cars, artificial intel-
ligence, drones, e-commerce and have very meaningful
implications for commercial and multifamily real estate. And
just as disruptors such as Airbnb, Amazon, and WeWork
are shifting demand and supply dynamics in the property
markets, new start-ups focused on CRE finance are doing
the same.
The CRE finance disruptors are increasingly present and
are changing the way in which borrowers and lenders view
the financing landscape, albeit slowly. An explosion of
well-capitalized, non-bank lenders and a growing number
of crowdfunding start-ups are exploiting the post-crisis
lending environment in which regulation rather than relative
value amongst lenders informs many a borrower decision.
Summer 2017 Volume 19 No. 2
Lisa Pendergast
Expectations are high that these lenders will mature over
time, and provide more competitively priced debt capital and
a more institutional and seamless delivery. CREFC stands
ready to work with both traditional and non-traditional
lenders to expand the availability of appropriately sized and
structured capital and ultimately drive measured and sound
growth in the sector.
Perhaps one of the more interesting and potent disruptors
emerged in November 2016, with the election of a Washington,
D.C. outsider as President of the United States. President
Trumps stated agenda of querying the way things have
always been makes him perhaps THE Disruptor of 2017
and beyond. To wit, in early February, the President directed
Treasury Secretary Steve Mnuchin to conduct a review of
financial regulations and to report back within 120 days on
possible regulatory or legislative changes.
The CRE finance markets are undoubtedly one part of this
effort. Again the CRE Finance Council will advocate for
those legislative and regulatory changes for which we have
consensus amongst our members. Where we do not, we will
seek to educate the appropriate regulators and legislators
on the varied views and opinions of our members.
So, enjoy this issue of CRE Finance World, exploring not
only evolution, change and disruption with CRE Finance,
but also providing updates on regulation, property markets,
the current strong demand for floating-rate debt and CMBS
loan performance. Finally, your feedback and suggestions are
vital in ensuring the continued high quality of the magazine
and setting the direction and tone for future editions.
With Kind Regards,
Lisa Pendergast
CRE Finance Executive Director
CRE Finance World Summer 2017
3
CRE Finance World
Editors Page
Disruption
Disruption that seems to be the theme of the last six
months. From the election of Donald Trump, to the Russia
scandal, to the proliferation of fake news (wellseeming
proliferation, maybe its that we all talk about it A LOT but
there really isnt that much of it), to the increased frequency
with which cyber-attacks are levied around the world, there
is much uncertainty, nay unpredictability, ahead. Incidents,
events and people seem to be either irrelevant specks on
the time continuum or disruptive forces that are shaping our
societies and economies.
Disruption whether it be of an industry or an economy
or through innovation is a process. It takes time. And
because it takes time, we often overlook the disruption
until it is too late. This highlights the importance of thinking
critically, engaging thoughtfully with other people, and
getting out and really seeing the world.
Now, I dont have a crystal ball and I cannot tell you what the
next really big disruption in our industry is going to be, but
I can see that there are disruptors out there making small
changes, steps forward, and leaps in innovation, every day.
Over time, these disruptions will impact and fundamentally
alter the way we do business.
CRE Finance World Summer 2017
4
Krystyna Blakeslee
Partner
Dechert LLP
In this issue of CREFW, we are excited to bring a bit of
disruption directly to you. We hope this issue will make
you stop, think, and analyze all that is around and what it
means (or doesnt mean) for the future of the commercial
real estate industry, especially.
This issue boasts articles that (I hope) will (i) challenge your
pre-existing notions about certain asset classes (like Retail
Store Closing Fiction), (ii) reshape the way you think about
CMBS and technology (like A Case for A.I. in CMBS),
(iii) help you to see the word (like Market Disruptors Are
Here to Stay!) and see connections within the broader
economy and CMBS (like Secular Trends Transforming The
CRE Landscape) and (iv) cause you to re-think regulation
and its impact on the industry (like Non-Bank Lending in
an Era of Bank Deregulation and Evaluating Alternative
Lending Platforms and Their Prospects Going Forward).
In addition to the articles referenced above, this issue, as
usual, is full of great analysis and useful information that just
might be the catalyst you need to be that market disruption
we are waiting for.
Krystyna Blakeslee
Partner
Dechert LLP
CRE Finance World
Foggy Outlook for Legislative,
Regulatory Relief
The 2016 election has great implications for regulatory
policy governing the commercial mortgage market, which in
recent years has been inundated with new rules in response
to the last financial crisis.
President Donald Trump and Republicans in both chambers
of Congress promised during the campaign to reduce
regulations on businesses and oppose tighter banking
industry rules such as those embodied in Dodd-Frank. In
early February, the President issued an Executive Order
(EO) asking regulators to review financial regulations, with
the expectation of delivering regulatory relief to banks
sooner rather than later.
However, implementing campaign promises is proving to
be anything but simple as every President in their first term
has learned. Nearly six months into the new administration,
very little is clear as to when (or how) regulations affecting
the commercial mortgage industry will change. Congress
has been consumed by other issues such as health care
and tax reform, and the administration has been slow to
propose detailed policy recommendations or appoint officials
to key regulatory and administrative posts that would work
on the issues.
With so many moving parts: A shifting political landscape,
Congressional Republicans learning how to function in
the majority, and an
administration with
The level of unknowns is high, no record to handicap,
the level of unknowns
even for Washington standards. is high, even for
Washington standards.
Amidst this backdrop, it is crucial that the commercial and
multifamily real estate industry remains engaged and its
collective voices heard.
Summer 2017 Volume 19 No. 2
Paul Fiorilla
Associate Director of Research
Yardi Matrix
Taxing the Real Estate Industry?
At our publication deadline, a slew of issues important to
the industry including tax reform, flood insurance, capital
and liquidity rules and bank regulations were being debated.
In late April, the White House presented the outline of a
tax plan that focused on lowering the corporate tax rate.
Details about issues important to the commercial real
estate industry such as buzz that interest deductions,
depreciation and 1031 Exchanges may be eliminated
remain unclear. Without a draft bill in either House of
Congress or a detailed plan from the Administration, it is
difficult to ascertain what really is on the table.
The White House and Republicans in Congress want to cut
absolute rates in a way that reduces revenue by $2 trillion
over 10 years. However, Congressional Republicans, for the
most part, want tax reform to be revenue neutral. Therefore,
they need to raise revenue to keep the tax reform bill from
increasing the debt. Thats where the discussion over
closing loopholes comes in. While the goal of a simpler tax
code with lower rates and fewer loopholes is commendable,
eliminating commonly used deductions would force significant
and potentially damaging changes in the way the real estate
industry operates. And, almost every industry has a differing
tax treatment that they prefer. When one is taken off the
table, another needs to be put back on the table
Just like health care, passing tax reform is likely to prove
difficult. Republicans are not united on policy, they have many
issues to resolve this calendar year (including the fiscal year
2018 budget, raising the debt ceiling and reauthorizing the
flood insurance program), and they face a Democratic filibuster
in the Senate for any large tax cuts that do not help the
middleclass. The GOP can get around that on budgetary
issues by using a procedure called reconciliation, which
allows the Senate to vote on a revenue-neutral bill by simple
majority, but that would mean tax cuts would be temporary
and might face legal challenges.
Effort to Fix Bank Lending Rules
In early May, the House Financial Services Committee
passed the CHOICE Act, sponsored by Chairman Jeb
Hensarling (R-Texas), along party lines. The bill, effectively
allows banks that hold 10% capital to be exempt from many
of the rules promulgated by Dodd-Frank. Although there is
CRE Finance World Summer 2017
5
CRE Finance World
a chance the bill could get passed by the full House, likely
along party lines, Senate Republicans are not likely to act
on the bill. The Senate requires 60 votes on such bills to
get through the chamber, and Republicans would need
to convince eight democrats to join them in voting for the
Choice Act, which appears extremely unlikely. If Dodd-
Frank changes are to be made, they are likely to occur
through the regulatory process, starting with Treasury
Secretary Mnuchins expected June report on the effects
of financial regulation on lending and liquidity.
For construction lending, CREFC is one of more than a
dozen real estate trade organizations supporting legislation
that would clarify the rules on acquisition, development and
construction (ADC) loans. The High Volatility Commercial
Real Estate (HVCRE) regulations were implemented jointly
by the Office of the Comptroller of the Currency (OCC),
Federal Deposit Insurance Corporation (FDIC) and Federal
Reserve. The regulations part of rules enacted to implement
Basel III in the wake of the last financial crisis that are
intended to de-risk bank balance sheets require banks
to set aside 50% more capital on loans deemed to be
high-risk (12% for HVCRE loans as opposed to 8% for
non-HVCRE loans).
Banks say that the added costs associated with HVCRE
make them less competitive versus other lenders. Martin
Schuh, head of government relations for the CRE Finance
Council, said the HVCRE regulations add as much as
50 basis points to the cost of a loan. The diminished
competitive position of banks has led to the rapid growth
of non-regulated lenders such as private equity funds and
foreign capital in this space.
Whats more, from the time the rules were enacted, banks
have complained that the HVCRE rules as written were
unclear and that guidance from the various agencies in
charge of compliance was often contradictory, and created
an un-level playing field for market participants. Confusion
was evident in early 2015 when banks re-classified loans
already on their books to comply with HVCRE.
The lack of clarity has negatively impacted ADC loan
decisions for some banks, leaving borrowers with fewer
and potentially more costly sources of ADC loan capital.
A slowdown in ADC lending has the potential for broader
economic impact, says a letter drafted by more than a dozen
trade groups, including MBA, CREFC, RER, the National
Apartment Association, the National Multifamily Housing
Council, and NAIOP Commercial Real Estate Development
Association.
In an effort to convince regulators to clarify the rules, the
CREFC, MBA and RER each formed HVCRE working
groups. The regulators did issue FAQ responses, which
many believe generally failed to appropriately address the
CRE Finance World Summer 2017
6
groups concerns. There is also a legislative fix underway.
Reps. Robert Pittenger (R-NC) and David Scott (D-GA)
introduced a bill, H.R. 2148, in the House in late April to
provide the necessary clarity on HVCRE loans for banks
Key Points of the HVCRE Bill
The proposed legislation would maintain HVCREs higher
capital charges, but clarify which loans are subject to the
rules. Key points of the legislation include:
G
 randfather loans that were originated before 2015.
E
 xempt acquisition/refinancing loans for performing
income-producing properties. The rules were meant
to require banks to set aside more capital for loans
considered to be riskier. But the requirement to include
acquisition loans means banks may have to set aside
higher capital charges for low-leverage loans on properties
with stable cash flows, although that is an area where
interpretations differ.
A
 llow sponsors to take internally generated capital out of
properties, provided the required 15% equity contribution
remains in place. To be qualified as a non-HVCRE loan,
the rule requires that all cash flow from a property stay
within the project until the loan is repaid. Such strict terms
are unappealing to borrowers.
A
 llow banks to withdraw the HVCRE designation after
the project meets the banks loan underwriting criteria for
permanent financing. As it stands, HVCRE status extends
for the life of a loan, even if the property becomes stable
and meets prescribed standards for non-HVCRE status.
A
 llow appreciated value of land to count versus the cash
equity contribution. Currently, to avoid HVCRE status, the
developer equity contribution on construction loans must be
a minimum of 15% of the as completed value. However,
the value of the land as determined by the regulators for
the developer equity contribution is the original purchase
price, not the current value. That becomes problematic for
certain construction loans in which the land was purchased
in years past and has appreciated in value.
In addition, the trade groups are looking for clarity and
tighter definitions of what constitutes a redevelopment
loan or how to treat preferred equity and mezzanine debt
in the capital structure.
The differences in interpretation have serious consequences
for banks. At a meeting sponsored by the associations
recently and held in the New York office of law firm Kelley
Drye, a representative of large regional bank said it reclassified
$1 billion of previously originated loans as HVCRE, which
required it to set aside roughly $50 million of new capital
and endangered the institutions commitment to the
commercial mortgage market.
CRE Finance World
The purpose of the legislation is not to eliminate the
regulatory agencies requirements to hold more capital, but
rather to clarify by definition the loans that should not be
classified as HVCRE, said Joe Forte, a partner at Kelley
Drye who moderated the recent bankers panel. And also to
conform provisions of the rule to existing applicable Federal
banking regulations such as FIRREA (the Financial Institution
Reform, Recovery and Enforcement Act of 1989).
Prospects for the success of the legislation is unclear. The
aims of the bill align with the public comments to reduce
regulatory burden on banks by Congressional Republicans
and President Donald Trump, so the path to passage
theoretically is favorable. However, the legislative environment
is clouded by disputes among Republican factions and
non-cooperation among Democrats who are in no mood
to compromise.
What should the commercial real estate market make of the
uncertainty associated with HVCRE?
First, legislative change will be difficult to accomplish and
take longer than expected in the current environment. To
gain passage with only Republican votes in the House, a
bill must appeal to some combination of moderates and
hard-liners. If that happens, it must survive the threat of
filibuster in the Senate. That doesnt mean a legislative
approach is impossible, but efforts must be carefully
calibrated. The bipartisan HVCRE legislation is an example
of a reform directed at a narrow issue sponsored by a
Democrat and Republican.
Second, relaxed
enforcement
The Administrations more immediate and reduced
compliance
solution could be to install leaders in hurdles for
the regulatory agencies who will be banks are going
to be hallmarks
less zealous about enforcement. of the Trump
administration
regulatory
culture. One of President Trumps first acts included signing
an executive order directing Federal agencies to reduce
the number of regulations. Slashing regulations already
on the books, however, is complicated because it requires
Congressional action and/or a lengthy rule-rewriting process
by regulatory agencies that can take years.
Summer 2017 Volume 19 No. 2
Given that, the Administrations more immediate solution
could be to install leaders in the regulatory agencies who
will be less zealous about enforcement, says Mark Calabria,
chief economist for Vice President Mike Pence. Personnel
is policy, Calabria said, noting that enforcement is one part
of the Obama era that can easily be replaced.
How to Reduce the Regulatory Burden
One of the chief objections to banking regulations imple-
mented in the wake of the last financial crisis is that the
rules as written leave a lot of room for interpretation, and
whatever banks do is subject to second-guessing from
regulators. Calabria, who joined the administration from the
Cato Institute, contends that our financial and regulatory
system is deeply flawed in many cases, straightforward
deregulation is the answer, but I recognize that the financial
system is complicated.
Brian Gardner, a senior vice president of bank research at
investment bank Keefe, Bruyette & Woods, also contends
that prospects for legislative change are not good given the
ideological differences between the House and Senate.
The best hope to reduce the regulatory burden is likely
to come from instruction that the new agency leadership
provides to staff. The first thing (the Administration) can
do is to instruct supervisors and examiners to change their
behavior, Gardner said.
It will take time to replace the heads of the agencies, though.
For example, Federal Reserve chair Janet Yellens term
expires at the end of January 2018, and Richard Cordrays
term as Director of the CFPB ends in July 2018. Some
House Republicans have urged President Trump to fire
Cordray, whose agency has drawn the ire of Republicans.
However, under Dodd-Frank, the CFPB Director is only
removable for cause. The removability of the Director by
the President is one issue in a case currently before the
D.C. Circuit.
CRE Finance World Summer 2017
7
CRE Finance World
Hurry Up and Wait! Banks
Continue to Implement
Basel IV though Timing of
Final Rules Still Unclear
The package of risk-based capital requirements informally
called Basel IV is still awaiting adoption by the Basel
Committee on Banking Supervision (BCBS) nearly seven
months after the first vote was planned. The vote on B-IV has
been postponed several times since last November, first
because of infighting about potential increases in capital
requirements and then presumably also for political reasons.
What does B-IV do?
BCBS members decided several years ago that the differential
between effective capital requirements from region to
region and from bank to bank was too high. They decided
that the trouble was the flexibility allowed into the risk-
based capital (RBC) framework starting with Basel II when
internal models were invited into the mix. Internal models
were seen as the answer to better estimations of potential
losses because they could be highly tailored. So now in
this turn around the bend, the BCBS is attempting to swing
the pendulum somewhere in between the risk-tailoring
of internal models and the certainty of outcomes in the
original Basel I regime.
At the most basic level, Basel IV seeks to achieve conformity
of outcomes through greater specificity around risk factor
inputs, imposing capital floors and swapping some internal
models for standardized approaches. The transition from
Basel III to IV may impact CRE portfolios more so than others,
especially CMBS and so-called repo financings drawn to
financial institutions. The charges related to CMBS are
expected to be at least two times those of comparable loan
portfolios and CRE loan portfolios are also expected to
require more in capital.
What Happened to the Vote on Basel IV?
In 4Q 2016, Germany said they would not adopt the Basel
IV rules last year. Behind the scenes they let it be known
that capital requirements for their banks would increase
well past their pain point.
Then in January 2017, Germany took over the presidency of
the G20 and took on a more conciliatory tone, partly due to
compromises promised by other BCBS members.
At the same time, President Trump took office and started
to search for nominees for key regulatory posts in the U.S.,
including the Federal Reserves Vice Chair of Regulation
and Supervision and a new Comptroller of the OCC.
CRE Finance World Summer 2017
8
Christina Zausner
Senior Director, Head of
Industry and Policy Analysis
CRE Finance Council
More recently, German officials publicly assured the U.S.
that the incoming leadership should be allowed time to take
their posts and to acclimate to the issues.
When Might Basel IV Move Forward?
In many ways, the bow to turnover in committee members
may benefit all sides. If the Germans, new U.S. leadership or
anyone else continues to express concerns about the level
of new requirements, then this pause is a convenience and
could go on indefinitely. Consider that the BCBS operates
on unanimity. Every member must vote and vote in unison to
adopt any measure. If a single member votes against some
requirement, the very foundation of the BCBS is threatened.
No one, not even the new U.S. Administration, has indicated
that they would prefer to pull out of Basel, not when the
consequences are so high. If a member violates requirements
or pulls out of the group, then other member countries are
free to limit that countrys banking activities abroad.
Historically, capital rules are difficult to agree upon, and this
may only be the beginning of the debate. Basel I was adopted
in 1988 and the group immediately began to fashion Basel
II, which was not fully implemented until roughly twenty
years later.
When will Banks in the US have to Conform to Basel IV?
As the BCBS continues to delay its vote, U.S. and other banks
are preparing for parts of B-IV. The segment of Basel IV known
as the Fundamental Review of the Trading Book (FRTB), which
covers CMBS, has technically already been finalized by the
BCBS, though the industry believes that the regulators are
revisiting the FRTB, along with all other parts of B-IV. As per
the final BCBS standards, the FRTB is on track for conformity
in the U.S. and elsewhere on January 1, 2020. The European
Union was the first to propose its version of the FRTB several
months ago and in that document, the authors pushed back
conformance to 2021 in tacit acknowledgment of the burden
and complexity of these requirements.
Though the industry expects the BCBS to revisit calibrations
of the FRTB methodologies, even though the banks have
begun to build the relevant infrastructure While this dialogue
proceeds between the industry and regulators, banks hope
that U.S. regulators will fall in line with the Europeans and
push back effective dates for the FRTB and B-IV in general.
In the meantime, the banks must guess at their requirements
while hoping for delays and mitigations.
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CRE Finance World

The Big Picture:

CREFC Legislative & David McCarthy
CRE Finance Council

Regulatory Update

(As of May 19, 2017) While drama may continue to unfold
at the White House, we do expect Congress to continue to
press ahead on key initiatives such as financial regulatory
reform, flood insurance and possibly tax reform. Financial
sector regulators are somewhat insulated from day-to-day
politics, but key changes in leadership, and possibly changes in
the law, will impact their agendas. Below we present a spot
check on both the legislative and the regulatory leadership
slates and agendas.
Legislative Spot Check
As shown below, Congressional Republicans have outlined
an ambitious package reforms and rollbacks. None have
made it to the Presidents desk as of yet. Tax Reform and
Healthcare can be accomplished without Democrats support
(if changed through the reconciliation process), but the
rest will need at least some bipartisan votes to break a
Senate filibuster. We do not expect to see wholesale reform
of Dodd-Frank (such as passage of the entire CHOICE
Act), but smaller bipartisan bills might gain traction as the
year progresses.

Issue Proposed Changes Roadblocks Status Timeline

Healthcare Repeal and replace of Passage in the House Passed House; Under Summer 2017
the Affordable Care Act was tough, passage in Senate consideration
(Obamacare) the more moderate
Senate will be tougher.
GOP can only lose 2
senators and still be able
to pass a bill.

Tax Reform Multiple plans, but most Some GOP leaders want No legislative action Post Healthcare,
seek to lower the cor- tax cuts to be revenue as no bill has been Q3 or Q4 2017
porate rate and reduce neutral by raising rev- introduced.
loopholes. Most call for enue through deduction
up front expensing and eliminations or a border
elimination of the inter- adjustment tax.
est deduction.

Financial Broad reforms to Dodd- Democrats have Passed out of House House vote in late May
CHOICE Act Frank and financial opposed certain Financial Services or early June. Senate
regulations. Exempts regulatory rollbacks. Committee; awaiting timing unclear, but
banks from stress test There is little appetite vote by entire House consideration highly
and capital requirements in the Senate for the unlikely
if they hold 10% capital. bill where it needs
Repeals Volcker and risk bipartisan support.
retention.

GSE Reform No unified plan; a Bipartisan support No legislative action 2nd Half 2017 and
number of proposals are necessary to move any beyond.
floating around reform in the Senate

CRE Finance World Summer 2017

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CRE Finance World Summer 2017 Volume 19 No. 2

Regulatory Leadership
Beyond the big-ticket reforms, CREFC expects leadership
turnover at the regulatory agencies to have an important
impact on policy and enforcement going forward. In many
cases, regulators have discretion to shape regulatory policy
in the scope of a broad statute. Leadership will be key.
Beyond Treasury Secretary Steven Mnuchin, the Trump
Administration has confirmed only one additional leader of
a financial sector regulatory agency, Jay Clayton as SEC
Chair. As you can see in the tracker, there are plenty of
important vacancies.
In particular, the Federal Reserves Vice Chair of Banking and
Supervision, which has been filled only on an acting basis
by other Governors, plays an important role in crafting bank
regulatory policy, both at the domestic and the international
levels. The position also takes the lead for the Fed at the
international Basel Committee on Banking Supervision.
Although there is an Acting Comptroller leading the OCC,
Secretary Mnuchin informed the Senate Banking Committee
on May 18 that President Trump had approved a nominee
and that was proceeding through the vetting process. The
nominee has not yet been announced.

Agency Leadership Transition

Treasury Secretary of Treasury: Steve Mnuchin

FDIC Chair Martin Gruenberg: Term ends Nov 2017

(1 Vacancy) Vice Chair Thomas Hoenig: Term ends 2018
Vacancy

Board of Governors, Chair Janet Yellen: Term as Chair ends Feb 2018 (Board term ends Jan 2024)
Federal Reserve Vice Chair Stanley Fischer: Term as VC ends Jun 2018 (Board term ends Jan 2020)
(3 Vacancies) Gov. Jerome Powell: Term ends Jan 2028 (named acting VC of Regulation and Supervision)
Gov. Lael Brainard: Term ends Jan 2026
Vacancy; Vice Chair of Supervision and Regulation (Randy Quarles possible Nominee)
Vacancy
Vacancy

OCC Acting Comptroller Keith Norieka (Joseph Otting possible Nominee)

SEC (3 Vacancies) Chair: Jay Clayton: Term ends 2021

Comm. Michael Piwowar: Term ends 2018
Comm. Kara Stein: Term ends 2017
Vacancy
Vacancy

CFTC (3 Vacancies) Chair: J Christopher Giancarlo (named Acting Chair and Nominee)
Comm. Sharon Bowen: Term ends Jun 2019
Vacancy
Vacancy
Vacancy

Regulatory Agendas
Once more agency vacancies are filled, the agendas will
begin to take shape. Were also awaiting two key documents
that may shed more light on priorities and timing: the
Unified Regulatory & Deregulatory Agenda and Secretary
Mnuchins Report on Core Principles for Regulating the
U.S. Financial System.
The twice-yearly Unified Agenda compiles agency rulemaking
schedules over the coming year and indicates timing, what
rules the regulators will take up, as well as providing status
updates on stages of rulemaking. From the Spring 2017
agenda, we will be able to see the regulators priorities.
The agenda usually is released in late May.
Secretary Mnuchins report is in response to President Trumps
Executive Order signed on February 3, 2017, which laid out
seven core principles and directed the Treasury Secretary to
examine the extent to which existing laws, treaties, regulations,
guidance, reporting and recordkeeping requirements, and
Government polices promote the Core Principles. The report,
expected in early June, will cover banking. We expect
this report and any subsequent reports will represent the
Administrations roadmap for regulatory reform. Implementing
these findings could involve both legislative and regulatory
action, but, as most of the financial regulators are independent
agencies, the Trump Administration has limited ability to
implement the findings directly. That independent structure
underscores the importance of the appointees in regulatory
or deregulatory actions.
Stay Tuned
Healthcare, tax reform, and Russia may dominate the head-
lines over the next few months, but opportunities remain for
action on financial industry regulation. Please reach out to
CREFCs government relations team and keep up to date
on our advocacy efforts on behalf of our members.

CRE Finance World Summer 2017

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 CRE Finance World EVOLUTION CHANGE
Market Disruptors
Are Here To Stay!
When we hear the words Market Disruptors we generally
think Google, Amazon, Airbnb, Uber, Netflix, and YouTube.
We all know the effect Netflix had on Blockbuster, YouTube
had on the record industry, and Uber had on the traditional
Yellow Cab. Just like the Industrial Revolution changed
the landscape from a rural economy to an urban-based
economy, technology is changing the business landscape
at an exponential rate. The shift has resulted (and will
continue to result) in a multitude of disruptions to various
market sectors. Seemingly, every time we go online, read a
magazine, listen to the radio or watch TV, we hear of a new
Market Disruptor or an existing player expanding its scope.
CNBCs Top 50 Disruptor list is projected to impact 15
industries, including financial services, medical services,
aerospace, cybersecurity, retail and media. The sharing
economy, automation, and technology have been the driving
forces behind these market disruptors. This begs the question,
how will the commercial real estate finance industry occupied
by these industries be affected?
To understand the broad reach and impact of these disruptive
factors, it is important to consider growth and footprint of
major disrupters, Amazon and Airbnb; the impact technology
and changing trends have of commercial real estate
spaces; and, finally, how commercial spaces are adapting
to disruption.
Disruptors: Investment and Growth
Bloom Energy envisions living off the grid and keeping
the lights on, and SpaceX is taking us to Mars. Pinterest,
Spotify, and Snapchat have become household names.
Corporate America seemingly overnight began utilizing
DocuSign, SurveyMonkey and Dropbox. CNBCs 2016
list of the Top 50 Disruptors reports $41 billion in venture
capital was raised in 2016, and the Top 50 Disruptors have
a combined market value of $242 billion. A dozen of these
companies raised $1 billion or more with the median raised
amount being $276 million. Fidelity alone has invested
in 13 of the Top 50 Disruptors including Snapchat, Uber,
Airbnb, Twilio, Oscar and SpaceX. Google Ventures was a
dominant player that invested in a dozen tech companies.
Foreign investment has joined the game and is fueling
growth. Uber received $3.5 billion from Saudi Arabias
Public Investment Fund, and Snapchat raised $200 million
from the Chinese e-commerce giant Alibaba. Snapchat
became a publicly traded company in March 2017 with
the latest valuation at approximately $17.8 billion.
CRE Finance World Summer 2017
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DISRUPTION
Abeer Ghazaleh
PGIM Real Estate Finance
Amazon is the behemoth of market disruptors. Amazon has
had a marked impact on the retail sector and is the leading
retailer of e-commerce. Amazon sales account for 8% of all
retail sales and 43% of online sales in the United States.
Net sales in 2016 were reported at $2.87 billion driven by
more than 304 million consumers. The Amazon Effect
has dealt a heavy blow to previous giants such as Borders,
Sears, JCPenney, Best Buy, Office Depot, American Eagle
Outfitters, and the list goes on and on. Announcements of
new closures are revealed on a weekly basis.
Amazon turned 21 in the summer of 2016. The National
Retail Federation ranked Amazon 26 on the Top 100
Retailers as of 12/31/2010. In contrast Amazon was ranked
eight as of 12/31/2016. Amazons ranking has steadily
improved year over year as illustrated in the below chart.
Chart 1
Amazon Ranking Top 100 2016
Former giants Sears and Best Buy have dropped off the
Top 10 list as Amazon gained market share. It has been
said time and time again, Americas malls are moving
online. The Financial Times reports as of April 4, 2017, the
consensus forecast amongst 49 polled investment analysts
covering Amazon.com, Inc. is that the company will continue
to outperform the market. This has been the sentiment of
forecasters since 2009. Amazon reported net income of
$2.87 billion in 2016.
A new company challenging a traditional industry is not
limited to the retail sector. Airbnb, a provider of travel
accommodation has served over 30 million guests since
its founding in 2008 and is valued at $10 billion. Without
owning a single room, Airbnbs valuation rivals those of
major hotel chains, like Hyatt. Airbnb exemplifies the sharing
economy concept. It derives revenue through service fees
from both the guest (9-12%) and the host (3%). Airbnb
built its online reputation by encouraging guests to rate
their experiences through a star point system. Airbnb quickly
became a threat to the hotel industry as travelers chose to
stay in Airbnb rooms instead of the traditional hotels. It is
estimated that hotels lose approximately $450 million in
room revenue and an additional $108 million in food and
beverage revenue annually due to Airbnbs penetration of
the hotel sector.
 CRE Finance World EVOLUTION CHANGE
According to an article published by Phocuswright (D. Quinby
2016), Airbnb is now the third-largest online seller of
accommodation worldwide, and it is probably the fourth-
largest online travel intermediary by gross bookings. Airbnbs
site is currently used by 50,000 renters daily. Airbnb had
one million available rooms in 2015, compared to Hilton,
Marriott and Intercontinental which each had approximately
700,000 rooms. It is extremely cost effective for Airbnb
to expand its platform by adding additional rooms through
subscribing new hosts. Unfortunately, adding rooms for
hotel chains is a costly proposition as the new product must
be constructed. In a Fortune article title Airbnbs Profits to
Top $3 Billion by 2020 (L Gallagher 2017). Airbnb projects
it will earn $3.5 billion a year by 2020 which translates to
more than the bottom lines of 85% of the companies in
the Fortune 500. Each 10% increase in Airbnb revenue is
estimated to result in 37 million room night bookings per
year. By comparison, each 10% revenue increase for Airbnb
translates to a 2-3% decrease in traditional hotel revenue.
In addition to loss of room and food & beverage revenue
for hotels, there is also an adverse impact to the collection
of local and state taxes which may not be applicable at the
same rate for Airbnb as they are for hotels.
Attempts to combat Airbnbs appeal to consumers have
largely been unsuccessful. As traditional hotels move to
DISRUPTION
Industrial properties have
undergone conversions
to residential units, film
studios, hotels, and mixed
use office/retail.
reduce room rates, (benefiting consumers) it results in
further revenue declines. Unsurprisingly the hotel/Airbnb
fight has shifted to the courtrooms and legislative bodies
across America. Given consumer appetite for this and
similar products, it will likely be a long, hard fought, and
expensive battle. Will hotels adapt and reinvent themselves
or will there be an oversupply in the marketplace? Only time
will tell the outcome.
Other travel sites such HomeAway, VRBO, and Expedia
are also in the online booking market sector. They provide
competition to both Airbnb and traditional hotels. Starwood
and Wyndham have implemented loyalty programs to boost
their bookings.
Disruptions to Commercial Real Estate
At CREFCs Annual Conference in January 2017, keynote
speaker Salim Ishmael went so far as to say the commercial
landscape as we know it today will be unrecognizable in the
next five years. Wow, I thought, thats a daunting prospect!
Because of that speech I have become sensitive to any
mention of Market Disruptors and how this phenomenon
is affecting uses of traditional commercial real estate.
Which property types are most impacted and potentially
becoming obsolete? How are these properties adapting in
the new world?
CRE Finance World Summer 2017
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 CRE Finance World EVOLUTION CHANGE
Nanotechnology could extend life span and eliminate
disease. How will that impact the medical, insurance, and
pharmaceutical industries, and, by extension, the physical
spaces in which they currently exist?
Drones will deliver goods to our doors. Our food will truly
come from the farm to table. What will the impact be to
the distributor, retailer, and space they occupy? Will the
neighborhood grocery anchor and retailers driven by foot
traffic disappear to be replaced by an Amazon distribution
center? In a recent conversation with my seven-year old
granddaughter, she was perplexed as to why I needed to
go to the grocery store. She informed me that Instacart
can bring me whatever I need and that no one goes to the
grocery store anymore. It was a bit disheartening to learn
from a seven year old how uncool and behind the times I was!
Self-navigating automobiles could prevent transportation
headaches and provide an accident free solution to commuters
within the next few years. The Business Insider published
an article titled Heres how Teslas self-driving cars see the
world (D Muoio 2016) which reported that Tesla will drive
a car in a fully autonomous mode from LA to New York
City by the end of 2017. Toyota also is also taking aim at
producing autonomous cars to counter efforts by Google.
This new mode of travel is anticipated to ease congestion
along with wear and tear to vehicles, roads and highways.
How will parking lots be impacted? Will there be a need
for insurance providers? What happens to the millions of
jobs currently supported by infrastructure maintenance,
development, and product manufacturing?
Adapting to Disruption
Commercial Property Executive published an article titled
The Trend of Adaptive Reuse (F. Romeo 2015). Mr. Romeo
states, On the most basic level, adaptive reuse can save
on overall building design, material and construction costs.
In general, these buildings have great foundations, facades
and structurally strong frameworks, which can remain
intact, while containing an abundance of existing core and
shell space that can be quickly and cost effectively renovated
to serve the needs of non-traditional tenants. Evidence
of adaptive reuse can be seen in multiple commercial real
estate sectors today, and below are just a few examples of
how malls, retail, office buildings, and even industrial spaces
are being reinvented.
The United States currently hosts approximately 1,200
indoor malls, of which only a third are performing well. Many
have adapted to challenges brought about by the internet-
era by adding attractions like aquariums, escape rooms,
fitness centers, day cares, and blow-dry bars to increase
foot traffic and maintain their relevance. Restaurants and
medical clinics are beginning to make up a larger portion of
CRE Finance World Summer 2017
14
DISRUPTION
the tenant mix at many shopping centers. Stores such as
Macys and JCPenney, in conjunction with implementing
store closures, are experimenting with store within store
concepts. They are partnering with the likes of Apple,
Sephora and DKNY to reduce their footprint and lease
expenses and to increase foot traffic.
Additionally, advocates of
New Urbanism contend that
dead malls are ideal sites
Which property types are
for sustainable community most impacted and potentially
centers, as large tracts and
empty concrete shells are becoming obsolete?
ideal for conversion into
multi-function suburban town
centers. Town centers combine residential, retail and office
properties into a concentrated area (a concept that has
proved enormously appealing to Millennials). Approximately
40 dead malls in the United States have undergone
transformation into suburban downtown areas.
Vacant Big Box space has been converted to a variety
of recreational and institutional uses including churches,
health clubs, and museums. Healthcare organizations have
found it cost effective to convert Big Box stores into clinics
as they are readily accessible to the community, expand
patient base, and offer ample parking.
Dated low-rise office properties are being converted into
schools and distribution centers (to accommodate the
online shopping appetite). On the other end, high-rise office
properties offer opportunities to expand the limited housing
supply in many metropolitan areas.
Industrial properties have undergone conversions to
residential units, film studios, hotels, and mixed use office/
retail. Even auto dealership sites have recently proved to
be highly desirable sites and structures for manufacturing,
such as a bottling plant in Michigan.
Conclusion
The sharing economy, automation, and technology are here
to stay! They will continue to develop at an exponential
rate changing lives, business practices, space occupied,
and world views. Many industries, including commercial
real estate must remain vigilant of the seemingly subtle
shifts within portfolios. These unprecedented advances
will also bring about moral and ethical questions regarding
their implications which will need to be addressed through
legislative bodies. Despite the challenges, change inevitably
brings with it tremendous opportunity. Society must be
prepared to facilitate rather than hinder the transformation
process. The alternative is to be left behind.

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CRE Finance World Summer 2017

15
 CRE Finance World EVOLUTION CHANGE DISRUPTION

Secular Trends
Transforming the Larry Kay
Senior Director
Kroll Bond Rating Agency
Eric Thompson
Senior Managing Director
Kroll Bond Rating Agency

CRE Landscape
Social and demographic trends will continue to shape the Warehouse tenant demand is not only coming from
commercial real estate landscape. The trends encompass e-commerce activity, but from a new tenant that has
a number of factors such as the size of each generational entered this space, the cannabis operator. After Colorado
cohort, lifestyle choices about marriage, child rearing and voters approved the use and sale of recreational marijuana
retirement, shopping behavior, work and leisure, and even in November 2012, warehouse rental increases in Denver
recreational drug legalization. reached double digit growth in 2013, which continued in
2014 and 2015. This compares with the national annual
Millennials (19 to 35 years old), which have surpassed the
rent growth during this same period of between 3 and 5%.
baby boomers (52 to 70 years old) to become the largest
In 2016, Denver appeared to be coming down from its
generation, are transforming the commercial real estate
marijuana high, with annual rent growth slowing to 4%.
industry. The lifestyle choices and work preferences of this
The slowing most likely reflects the increase in building
cohort will increasingly influence the use and configuration
deliveries which jumped in 2014 and then again in 2016
of real estate space. For those properties that adapt to the
lifting the vacancy rate to 3.9% in Q4 2016 compared to
new world order of space usage, intrinsic value should be
3.2% in Q4 2015.
enhanced, for those that dont, higher vacancies, or even
obsolescence could result. Exhibit 1
Warehouse Rent Growth
In the report that follows, we will explore some of the secular
trends that are driving the demand for, and shaping the
future performance of CMBS property collateral.
E-Commerce and Marijuana Light Up
Warehouse Space
E-commerce continues to command an increasing percentage
of total retail sales. Based on U.S. Census data, Q4 2016
e-commerce accounted for 8.3% of total retail sales
compared to 7.6% Q4 2015. Jones Lang LaSalle estimates
that 3040% of demand for industrial real estate has some
type of connection to e-commerce.
Retailers in the past typically processed their e-commerce
sales at their brick-and-mortar locations. With the emphasis Source: CoStar Group
on logistics and proximity to customers, retailers are now Exhibit 2
more often utilizing fulfillment centers or revamping existing Denver Warehouse Deliveries and Vacancy Rate
distribution centers to accommodate e-commerce growth.
This supply chain reconfiguration plays into the instant
gratification that e-commerce shoppers wantshortening
the time between the click on their computer and the knock
on their door for the delivered goods. Fulfillment centers are
being developed near major population areas to help assure
same-day delivery. Amazon clearly dominates this industrial
space and its website notes that it has more than 70 fulfillment
centers in the U.S., including 26 that were added in 2016.

Source: CoStar Group, Kroll Bond Rating Agency, Inc.

CRE Finance World Summer 2017

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 CRE Finance World EVOLUTION CHANGE
In November 2016, California legalized the use of recreational
marijuana. If the rent growth that Denver experienced is any
indication of what could happen in California, the countrys
most populous state, the impact to warehouse space
fundamentals could be even greater. However, the cannabis
warehouse business is not without its challenges. Building
owners that add marijuana tenants new to the business, or
lease to inexperienced operators, will likely face a higher risk
of tenant defaults. In addition, tenant improvements will need
to be made to maintain this type of operation including
specific lighting systems and expensive security systems.
In addition to the risk and cost of running a cannabis
warehouse business, another challenge for landlords is
that although marijuana may be legal in some states, under
federal law, it remains a Schedule I controlled substance,
illegal for any use. As a result, KBRA does not expect to
see CMBS loans collateralized by properties with tenants
engaged in marijuana-related activities for as long as
marijuana remains a Schedule I illegal narcotic under
federal law.
However, with 28 states and the District of Columbia
legalizing marijuana for medicinal purposes and with more
than 20% of the U.S. population living in states where
recreational marijuana is legal, as well as the expected
continued growth in e-commerce, warehouse demand
should remain intact.
Online Retailers Check Out Neighborhood
Shopping Centers
While the rise of e-commerce has benefitted the industrial
sector, its increasing share of total retail sales has had a
crippling effect on bricks-and-mortar retail. A recent UPS
survey of online shoppers found that for the first time in
the studys five- year history, on average more than half of
the shoppers purchases were made online. Among online
retailers, Amazon stood out: the 800 pound e-commerce
gorilla accounted for 43% of 2016 online sales in the U.S.
Exhibit 3
Amazons Share of Online Sales
Source: Internet Retailer
The secular shift to e-commerce sales has contributed to
recurring announcements of store closures and retailer
bankruptcies, including those of JCPenney, Macys, and
Sears, and the liquidation of Sports Authority, among others.
Regional mall operators have struggled from reduced foot
traffic due to the loss of anchors, as well as increased
DISRUPTION
vacancies from in-line tenants. As this has occurred,
bricks-and-mortar retail has been searching for a way
to provide shoppers with an experience that cannot be
replicated online.
The future of the retail industry will not only be on the Web,
but also in creating omni-channel offerings that integrate
the online and bricks-and-mortar experiences. While this
has been going on for years as traditional retailers have
expanded their online presence, the tables have turned as
e-commerce outlets are now opening physical storefronts.
Amazon has been at the forefront of e-retailers that are
utilizing bricks-and-mortar integration. It recently opened
a physical grocery store (1,800 sf) in Seattle. Based on
recent articles, Amazon may be exploring other test grocery
store locations. If these test stores are successful, we would
expect others to follow. That may not be the only threat to
the supermarket or grocery store. Millennials are visiting
supermarkets less frequently than previous generations did.
They are increasingly purchasing their groceries through
online outlets such as Fresh Direct and Peapod. According
to a report by the Food Marketing Institute and Nielsen Co.,
70% of all shoppers say they expect to buy groceries online
during the next ten years. In 2016, 28% of millennials
bought groceries online.
However, anchored neighborhood shopping centers that
provide needs-based goods and services are expected to
continue being a viable retail format. Despite this, centers
that are in trade areas which have experienced in-migration
from millennials may be adversely impacted by that groups
greater tendency to shop online. In addition, neighborhood
centers with grocery anchors could also be negatively
impacted in such markets, particularly if Amazon expands
its grocery business.
Exhibit 4
Percentage of Households Buying Groceries Online
Source: Food Marketing Institute, The Nielsen Co., Internet Retailer
Generational Gap Does Not Divide Living Preferences
Demographics and living preferences are also shaping the
multifamily sector. According to the U.S. Census Bureau,
the number of millennials (75.4 million) surpassed baby
boomers (74.9 million) in 2015. As the largest generation,
millennials will be a major force in future housing demand.
CRE Finance World Summer 2017
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 CRE Finance World EVOLUTION
Lifestyle choices among both groups, however, will ultimately
determine living accommodations, with multifamily most
likely to be the prime beneficiary.
Exhibit 5
Population Estimates by Generation
Source: Kroll Bond Rating Agency, Inc.; U.S. Census Bureau
Millennials are delaying marriage and childbirth until later
in life, events that have tended to increase demand for
single-family housing. According to a Gallup poll, 27% of
millennials are currently married, compared to 48% of baby
boomers that were married at the same age based on U.S.
Census Bureau data. With home purchases by millennials
being postponed, many are able to save money for down
payments. However, those seeking to purchase a home may
face obstacles, as lending requirements have generally been
more stringent following the housing crisis. Furthermore,
many millennials have outstanding student loan debt, and
according to Experian, have the lowest average credit
score of all the generational cohorts. In addition to credit,
affordability is emerging as the number one concern among
homebuyers. For millennials, affordability fears are even
more severe, with 32.5% naming it their top concern.
Exhibit 6
Millenials: Top Home Ownership Concerns
Source: Kroll Bond Rating Agency, Inc.; Redfin
While financial and credit issues may lead millennials to
multifamily, other reasons that may make renting preferable
for this cohort are more lifestyle related, as they seem to
CRE Finance World Summer 2017
18
CHANGE DISRUPTION
be reluctant to put down roots in a particular community.
According to the U.S. Bureau of Labor Statistics, millennials
only stay with the same employer, on average, for three years.
Based on these factors, it is no surprise home ownership
is being delayed. In a 2015 analysis, Zillow, a real estate
database company, found that Americans now rent for an
average of six years before buying their first home more
than twice the comparable figure in the 1970s of 2.6 years.
Accompanying this statistic, the home ownership rate has
been on a steady decline. Despite an increase to 63.7% in
Q4 2016, the home ownership rate fell to its lowest level
since the Census Bureau began tracking the figure in 1965
during Q2 2016, of 62.9%.
The home ownership rate is expected to continue to decline
not only because millennials are putting off their home
purchases, but also because baby boomers do not want to
be tied down to larger, underutilized suburban homes as
they age. As a result, they are downsizing to smaller rental
quarters. On top of smaller accommodations, boomers also
want the flexibility that a multifamily rental can provide so
they can pick up and move to be near their children and
grandchildren. City living could possibly be a viable alternative
to those baby boomers that may want to increase their cultural
experiences, and also have easier access to restaurants and
shops. Urban living may also allow boomers to live in closer
proximity to better healthcare choices.
Although age may be the great divide between millennials
and baby boomers, housing preferences at present are not.
The My To Our Office Space Transformation
With baby boomers retiring from the workplace and millennials
moving in, the shift in workforce demographics has forced
corporations to rethink their space needs. As a result,
corporations have been reconfiguring their office space as
they look to attract millennial employees. Individual work areas
are becoming less about corporate rank and more about
functional use. In addition, with more office staff working
remotely and corporations employing outside contract
workers for flexibility, companies have reduced their space
needs. According to a 2017 Gallup survey, from 2012 to
2016 the number of employees working remotely rose by
four percentage points from 39% to 43%. As more people
work away from the office, corporations have moved to open
space arrangements with hybrid floor plans. According to a
survey by the International Facility Management Association,
about 70% of U.S. companies have some type of open
floor plan.
Workspaces have become smaller, as technological advances
and mobile devices reduced the number of workers that
require a desk. According to CoreNet Global, an association
of corporate real estate and workplace professionals, office
space per worker is expected to continue to decline. From
600 square feet per worker in the 1970s, office space fell
to 225 sf in 2010, and could decline to 150 sf this year, based
on the most recent statistics available from the company.
 CRE Finance World EVOLUTION CHANGE
Exhibit 7
Office Space (SF) Per Worker
Source: Kroll Bond Rating Agency, Inc.; CoreNet Global
Provided it is economically viable, landlords may seek to
repurpose buildings that cannot accommodate the new
workforce. Generally, the buildings that are repurposed are
those Class C properties that are less competitive, and in
some cases obsolete due to outdated infrastructure and
technological deficiencies. Gensler Analytics, a global
architecture, planning, and consulting firm, has determined
that approximately 185 million sf office space may be
considered obsolete and an additional 300 million sf may
not be competitive due to lack of building upgrades. This
amounts to about 6% of the total U.S. office stock.
Corporations are not only reducing their own leased space,
but are utilizing space more frequently through co-working
centers. Shared space provides companies with the ability
to scale up or down depending on the companys needs
without committing to a multiyear lease. This arrangement
can also be attractive for tenants that may not want to
obligate themselves to either the traditional or the hybrid
office structure. Start-ups might find shared workspaces
especially attractive, as may companies whose industries
face large seasonal variations in business needs. According
to Statista, an online statistics and research portal, world-
wide there were 7,800 shared office spaces in 2015. This
number is expected to reach 37,000 by 2018.
Exhibit 8
Global Number of Coworking Spaces
Source: Kroll Bond Rating Agency, Inc.; Statista
DISRUPTION
But as with hybrid office space, shared office space comes
with drawbacks. Workers may be interrupted by others
from unaffiliated companies looking to network or socialize.
They may also be noisier than individually leased or owned
offices, and with less ability to keep work private. However,
co-sharing work space is expected to continue to grow, as
a new generation that prefers a flexible work environment
enters the workforce.
Hotels Are Not Taking Airbnb Lying Down
Airbnb, an online community marketplace for room accom-
modations, continues its rapid growth and popularity with
millennial travelers. These young travelers have gravitated
towards Airbnb as it provides them with a nontraditional
lodging experience at an affordable price. This sought-after
cohort currently makes up over one-third of the worlds
hotel guests. According to the Cornell Center of Hospitality
Research, it could represent 50% of all travelers by 2025.
Airbnbs business model relies on hosts renting out their
extra bedrooms or unused properties on a short-term basis.
It has resulted in an online hospitality platform of roughly
three million global rental unit listings. According to a recent
Smith Travel Research (STR) study, this figure is more than
the number of listings for the next three largest traditional
hotel companies combined. The study indicated that Airbnb
had a fairly small market share across 13 global markets,
with less than 4% of total demand and 3% of revenues. STR
also reports that one-half of the rooms listed on Airbnb are
sold for seven days or more. This challenges the conventional
wisdom that Airbnb typically competes for the short-term
or daily traveler. Based on STRs analysis, it may compete
more directly with extended stay properties.
Exhibit 9
Largest Lodging Companies by Rooms/Listings
As of November 2016
Source: STR, Kroll Bond Rating Agency, Inc.
Airbnbs Average Daily Rate (ADR) appears to be very
competitive especially on weekends, when there is stronger
competition for leisure travelers. According to the STR study,
U.S. hotel ADR on weekends has a negligible 2%8% price
premium over Airbnb. On weekdays, however, the premium
is 14%23%, reflecting more demand, higher occupancies,
and less price sensitivity from corporate travelers. As
CRE Finance World Summer 2017
19
 CRE Finance World EVOLUTION CHANGE DISRUPTION

millennials move into the corporate world and are in positions Ideas are
that oversee travel accommodations, an increase in Airbnbs
corporate clients could narrow the weekday price spread.
the new
Some of this increased business activity is already occurring
with last years announcement that American Express Global
currency.
Business Travel will integrate Airbnb into their platforms. Which is why it pays to think big.
As a result, its employees and travel managers are able to Youll get a powerful, integrated
book stays with Airbnb. Airbnb estimates that 10% of its financial platform, and keen market
bookings are for business travel. insights and strategy from our
team of experts. Because at Key,
Exhibit 10 we see what others dont.
U.S. ADR by Day of Week
July 2016, 12-month moving average

To learn more, contact:

Joe DeRoy
CMBS Program Manager
joe_a_deroy@keybank.com
913-317-4260
Matthew Ruark
Head of Commercial Production
matthew_t_ruark@keybank.com
913-317-4237

Visit key.com/realestate
Banking products and services are offered
by KeyBank National Association. All credit,
Source: STR, Kroll Bond Rating Agency, Inc. loan and leasing products subject to credit
approval. Key.com is a federally registered
For years, travelers have been booking hotel rooms through service mark of KeyCorp. 2015 KeyCorp.
KeyBank is Member FDIC.
online travel agent (OTA) sites including Expedia, Orbitz, ADL8220 150727-6205
Priceline, and Travelocity. Some of the larger hotel chains
such as Hilton Worldwide have been responding by offering
discounts to customers that book directly with the hotel chain.
In 2016, both Hilton and Marriott aggressively implemented
direct booking and loyalty marketing campaigns.
With Expedias acquisition of HomeAway, Orbitz, and TRUST THE
Travelocity, merger and acquisition activity in the sector has
picked up. Hotel consolidations have been occurring as
chains look to increase scale, improve operating efficiencies,
and maintain a larger marketing budget for national campaigns.
CMBS DATA
Hotel mergers and acquisitions activity typically follows
economic cycles. However in our view, the secular online PROVIDER OF
THE YEAR*
threat of peer-to-peer accommodations will persist.

FOR YOUR RESEARCH,

DATA AND ANALYTICS

TREPP.COM I 212.754.1010

*As determined by voters in the GlobalCapital 2017 US Securitization Awards

CRE Finance World Summer 2017

20
 CRE Finance World EVOLUTION CHANGE
Non-Bank Lending
in an Era of
Bank Deregulation
The decade since the financial crisis has been challenging
for our nation overall, but it has been a fertile period for
non-bank real estate lenders. The great majority of Americans
were angered by what they saw as reckless and sometimes
cynical behavior by both commercial and investment banks
who profited immensely from lax lending practices, and
then needed taxpayer bailouts to avoid bankruptcy. As a
result, Congress passed new rules, mostly generated from
the Dodd-Frank Act, that greatly restricted bank lending to
real estate investors and developers of any kind.
A new wave of non-bank lenders sprang up to fill the void.
This includes start-up lending funds, some of which have
grown to have billion-dollar balance sheets, as well as the
most established real estate private equity firms, most of
whom have launched non-bank lending programs of one
kind or another.
But with the changes in Congress and the Administration, it
now seems likely that the pendulum will swing back toward
less restrictive bank regulation.
This article examines three topics:
(1) What is the state of non-bank real estate lending today?;
(2) W
 hat factors have allowed this industry to grow and
thrive?; and
(3) H
 ow are non-bank lenders likely to evolve in the
years ahead?
Non-Bank Real Estate Lending Today
In the past, there was a clear distinction between institutional
lenders on one hand including banks and insurance
companies and private or hard money lenders on the
other. The gap between the two worlds was wide, in terms
of both pricing and standards of professionalism.
Today, non-bank lending covers a wide range of loan types
and sizes. Pricing in some cases is very competitive with
bank pricing. The hard money niche still exists but the
space in between hard money and institutional lending has
filled in with hundreds of lenders offering every type of loan.
These lenders tend to break down into a number of groupings
based on factors which include the following:
DISRUPTION
Jan B. Brzeski
Arixia Capital Advisors
L oan Size. Different lenders compete in different parts of
the market, with pricing often lower for larger loans because
of the economies of scale involved in underwriting and
originating such loans. Also, larger loans are usually floating
rate, while smaller loans are often offered at fixed rates.
Multi-billion dollar lending vehicles tend to focus on loans
of $20+ million and they often prefer $40+ million loans.
Loans of $5$20 million tend to attract their own lenders
whose funds may be in the hundreds of millions. Within
this grouping there are many lenders who prefer $10+
million loans and others who usually stay below $10
million. Loans under $5 million attract their own group
of lenders usually local and regional companies rather
than national ones. Finally, the market for loans under $1
million tends to be occupied by mortgage brokers who
work with affluent individual investors, matching each loan
with one or more investors.
Loan Maturity. Bridge loans of 1224 months attract a
dedicated group of lenders who are set up to handle a
large volume of transactions with relatively quick payoffs.
These lenders tend to hold loans on balance sheet until
maturity and often service the loans they originate,
because securitization makes more sense for loans that
will be outstanding for several years. Bridge lenders often
market themselves as being able to close quickly, usually
in under 30 days. Certain bridge lenders offer to close in
710 days, in order to justify higher rates or origination
fees. Many bridge lenders focus on the as-is value of the
collateral, and probably wont require that the asset be
able to cover debt service. Other lenders offer maturities
of 25 years, featuring lower rates. Often these lenders
require enough income in place at the time of closing to
cover debt service. These loans on transitional assets
are attractive when the business plan for the property will
take time to implement, such as if some leases will not roll
over until 23 years from the time of funding.
Specialty Lenders. Some lenders focus on a particular
asset type, such as single family homes. Within this
category there are sub-specialties including fix-and-flip
lenders (which was the original focus of Arixa Capital, the
authors company), rental houses (for example, B2R which
is owned by Blackstone Group) and construction lending
on for-sale housing. Other specialties include hospitality,
senior assisted living and even cannabis-related properties.
CRE Finance World Summer 2017
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 CRE Finance World EVOLUTION CHANGE
What Factors Have Allowed Non-Bank
Lenders to Thrive?
The most successful non-bank lenders today often have an
entrepreneurial culture and a can-do attitude. They embrace
short deadlines and try to solve problems to get loans
closed, rather than focusing on meeting strict and arbitrary
lending criteria. This, in short, is why they are thriving and
taking market share away from banks which rarely have an
entrepreneurial approach to lending.
To understand todays lending landscape, it helps to start
with a simple question: what advantage do banks have as
real estate lenders in the first place? The answer is, they
have a very low cost of capital because of deposits from
individuals and businesses on which they pay under 1%
interest per year. To avoid runs on the banks, such as
those during the Great Depression, these deposits are
insured against any losses by the FDIC. In other words, we
the taxpayers are guaranteeing that even if a bank fails,
depositors wont lose money. In the financial crisis, the
Troubled Asset Relief Program invested $700 billion to
prop up bank balance sheets.
Banks very low cost of capital comes with strings attached.
You and I as taxpayers have an interest in not seeing banks
pursue risky investments. Otherwise, bank executives could
make huge profits most of the time, pursuing more aggres-
sive investments, and then walk away from the rubble when
their banks failed every time a crisis emerged, leaving tax-
payers to foot the bill. This is exactly what most Americans
believe banks did before and during the financial crisis.
This perception whether it is true or not has weakened
the fabric of our society in meaningful ways. Consider the
anger on the part of most citizens against the 1%, against
commercial and investment banks, and against other elites.
It is impossible to imagine the uprising by outsiders against
insiders that brought Donald Trump to power without
the backdrop of the financial crisis and the deep-seated
resentment about perceived unfairness built into our
economic system.
It would be simple to say that non-bank lenders have thrived
because of excessive bank regulation after the financial
crisis. However, this view misses the larger point. The bank
regulation after the financial crisis was a reaction to the fact
that taxpayers really are footing the bill for any future bank
bailouts. Too big to fail means that large banks are basically
utilities, too important to our economy to be allowed to fail.
Smaller banks may be allowed to fail, but the FDIC and
ultimately taxpayers like you and me must still pay up if the
FDIC ever became insolvent. Free markets function well most
of the time, but our society already has major, unavoidable
areas of government intervention. It wouldnt be fair to
give banks special protection without requiring something
substantial in return. In the case of banks, that something
is strict monitoring of banks balance sheets and lending
activities, and penalties in the form of increased capital
requirements for those banks who choose to make loans
with higher risk.
Non-bank lenders have thrived because they are free to
provide exactly what their borrowers require, without regard
CRE Finance World Summer 2017
22
DISRUPTION
to the special regulatory burden that rightly accompanies
being a public utility guaranteed by taxpayers. Non-bank
lenders usually charge higher interest rates than banks
sometimes significantly higher however they also perform
a valuable service for borrowers. They free the borrower
from needing to deal with a highly regulated lender, which
saves the borrower a great deal of work. Just as banks need
a lot of extra compliance employees to make sure the bank
will pass regulators inspections and audits successfully,
real estate investors and borrowers who deal with banks
essentially take on some of this burden in the form of extra
employees whose main job is to provide banks with all the
documentation and other requests they need every week.
Non-bank lenders enjoy lighter regulation than banks because
they have no deposits and no government insurance. If a
non-bank lender loses 100% of its investment in a portfolio
of loans, the investors in that lender will lose their principal.
But such investors are typically sophisticated wealthy
individuals and partnerships who have been made aware
through SEC-mandated offering documents of the risks
associated with investing in a non-bank lending vehicle.
Future Trends Among Non-bank Lenders
In the coming years, it is likely that the trends since the
financial crisis will continue. Some of those trends include
the following:
The volume of non-bank lending will grow. In California the
Department of Business Oversight tracks mortgage lending
by non-banks. They report that licensed lenders originated
537,757 mortgages in 2015, up 47.3 percent from 2014s
total of 365,045. The aggregate principal for mortgages
originated in 2015 grew 56.7 percent from 2014, to $179.3
billion from $114.4 billion. Expect this trend to continue and
to be mirrored across the U.S.
Non-bank lenders will continue to become more
professionalized . As many lenders approach or surpass the
billion dollar mark, they are adding all sorts of highly refined
services. This may include technology designed to make
borrowers lives easier, or simply better training for their
employees. The coming years are likely to produce for the
first time in recent memory nationwide brands offering
bridge loans to real estate investors and developers.
Traditional hard money lenders will fade as fund-based
non-bank lenders grow. Hard money used to consist of
brokers who matched real estate owners and investors
needing quick funding with investors wanting a good return
on their money. Increasingly, the model of matching loans
with investors is giving way to debt funds who charge less,
offer more transparency on pricing, and who have a lot
more capital available to put to work.
Increasingly non-bank lenders will compete on pricing
with banks. As leverage becomes more available to real
estate lending funds often at attractive rates these
funds can price their loans closer and closer to bank rates.
This is already true for larger sized bridge loans in the many
tens of millions of dollars. As interest rates rise and bank
lending rates increase, expect to see a convergence of
rates between bank and non-bank lenders on smaller
balance loans as well.
 CRE Finance World EVOLUTION CHANGE
Evaluating Alternative
Lending Platforms
and Their Prospects
Going Forward
Traditionally, commercial real estate borrowers only option
was to approach banks or other traditional lenders when
seeking out a loan, a process that can be inconvenient and
time consuming. Today, a wide variety of commercial real
estate alternative lending platforms exist that can provide
convenience and time savings, as well as flexibility for
borrowers who may not be able to get loans approved from
traditional lenders for a host of reasons. These platforms
Today, a wide variety of commercial
real estate alternative lending platforms
exist that can provide convenience
and time savings as well as flexibility
for borrowers.
DISRUPTION
Gary Bechtel
President
Money360
offer many benefits to lenders as well, such as direct access
to loans, resulting in lower costs and higher returns.
Whats the Market for CRE Alternative
Lending Platforms?
Commercial real estate presents a $3.3 trillion opportunity
for online lenders far greater than other peer-to-peer
markets such as consumer ($2 trillion) and student loans
($1.3 trillion).
With nearly $300 billion in loans coming due in the next
18 months, alternative lenders in commercial real estate
will have opportunities to fill the void left by other lenders,
curtailing their lending activities and giving borrowers
quicker access to funds at better terms than what may be
offered by many traditional lenders. According to American
Banker, the industry has grown by nearly 700 percent over
CRE Finance World Summer 2017
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 CRE Finance World EVOLUTION CHANGE
the past four years. These platforms are already shifting
the world of commercial real estate finance, and will only
continue to grow over the next several years.
With increased regulatory oversight within the commercial
mortgage-back securities (CMBS) and banking industry in
recent years, the pressure on traditional lenders is increasing,
limiting their ability to provide new construction loans and
refinance existing loans. As a result, alternative lenders are
moving in to fill the gap and will become more necessary
than ever to keep up with the demand for capital.
Crowdfunding vs. Marketplace Lending
Crowdfunding is one alternative lending method that is
gaining popularity in the commercial real estate space.
While these platforms typically raise money from many
different investors, if not enough people contribute to fund
the full transaction, all of the investments may fall through.
Crowdfunding platforms also typically have limited options
when it comes to loan terms and dont match borrowers and
investors based on the best fit, making it a less effective
platform than more tailored lending platforms.
Marketplace or peer-to-peer lending is another popular option.
These platforms match borrowers and lenders, giving
borrowers timely access to funds from either individual or
institutional investors, depending on the platforms strategy.
The marketplace lender sources, underwrites and services
the loan, while marketing it to potential investors, typically
after it has been funded. The lenders set the loan rates and
terms of the loans they originate.
What is the Role of Technology?
In addition to expediting the process of finding an appropriate
borrower or lender, marketplace platforms allow investors
to review a variety of investment options in one place, do
their research, and stay up-to-date on the latest investment
opportunities. Investors and borrowers are updated in real-
time during each step in the loan transaction, increasing
transparency and reducing the back-and-forth lag in
communication that occurs with traditional lenders.
Technology allows these platforms to be more accessible
and easier to navigate, but the key is to have a team of
knowledgeable professionals in commercial real estate
financing with years of underwriting experience behind the
company. Alternative lending platforms should use technology
when beneficial to streamline processes, but investors and
borrowers should be wary of platforms that use technology
at the expense of human judgement.
What Are the Benefits of Commercial Real Estate
Marketplace Lending?
In addition to providing much-needed capital for borrowers,
marketplace lending offers investors access to a wide range
of commercial real estate debt at varying rates of return
CRE Finance World Summer 2017
24
DISRUPTION
that are typically highly-competitive, and often better, than
other fixed-income investments. Marketplace lending offers
many options, from smaller interests in larger loans to whole
loans, for investors seeking higher yields than those offered
by traditional fixed-income investments, such as CDs and
U.S. Treasury bonds.
In addition to attractive yields, the fact that real estate debt
is secured by collateral unlike unsecured debt such as car
or student loans and credit card debt makes it a less risky
investment prospect. Often times the investment property is
income-producing, further reducing the risk in comparison
to unsecured debt.
How Should Investors Evaluate Potential Opportunities?
Marketplace lending can be more effective and efficient than
traditional loans, but only if done correctly. Every commercial
real estate loan is different, and both investors and borrowers
need to find the platform that is most appropriate for them
based on the underwriting process and criteria. A casual
investor looking to invest $1,000 has different requirements
than an accredited investor with $250,000 in capital. Alter-
native lending platforms need to have experienced teams
on staff to ensure lenders and borrowers are matched
appropriately, that both parties are educated about the
terms of the loan and that the loans are originated and
unwritten correctly.
Besides the loan platform itself, there are many types of
commercial real estate loans investors can choose from
when evaluating potential opportunities. Each opportunity
should be evaluated based on the investors goals, risk
tolerance, timeline, diversification preference and overall
portfolio strategy, but there are some general rules to keep
in mind.
Permanent and bridge loans typically are less risky because
they are in a first lien position, secured against a property,
and the loan structure has a defined rate of return with
regularly scheduled payments. Equity loans, on the other hand,
do not have a defined rate of return but offer the ability to
have a permanent stake in the real estate. For investors
seeking more diversification and less risk, professionally
managed, low-cost commercial real estate funds that pool
these investments can be an attractive option that some
marketplace lending platforms offer.
Gary Bechtel serves as president of Money360, the leading
commercial real estatemarketplace lending platformthat caters
to institutional and accredited retail investors. Prior to joining the
company, he was chief lending/originations officer of CU Business
Partners, LLC, one of the nations largest credit union service
organizations (CUSO). He can be reached at garybechtel@
money360.com or (949) 525-9311. Learn more at money360.com.
 $ BILLION
$ BILLION ORIGINATED $ BILLION SERVICED

FIXED | FLOATING | AGENCY

$54.6 billion originated since 2010. $56.1 billion loans serviced as of February 28, 2017.
California loans will be made or arranged pursuant to a Finance Lenders Law License.

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DALLAS SEAT T LE WASHING T ON, D.C. SAN FRA N C I S C O
IR VINE BO ST O N COLUMBUS NASHVILL E

WWW.CCRE.COM | 212.915.1700

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demands, delivering commercial
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CRE Finance World Summer 2017

25
 CRE Finance World EVOLUTION CHANGE
A Case for
A.I. in CMBS
The concept of Artificial Intelligence (AI) engenders both
hope and fear we have all seen fantasy movies in which
servile robots support human masters or Matrix-like dystopian
worlds in which robots run amok. More concretely weve
seen how automation is the leading cause of labor force
displacement (far and away more impactful than outsourcing
or immigration, see Quick Reading Suggestions below).
It is difficult to grasp just how disruptive AI will eventually
be, but one thing for sure is that its influence is notable and
growing: examples include the way Alexa or Siri listens to
and interprets our words, innovations in automotive safety,
the simple Google search, smart e-mail boxes that detect
and filter our spam, and robots in logistical warehouses
(which enable Amazon to mail packages within minutes of
a mouse click).
Given the ubiquity of AI in our lives, surely it will play a big
role in business. What is the relevance of AI for commercial
real estate and CMBS? Will machines ultimately change the
way we do our jobs? Our view is a demonstrable yes, but
with qualifications. In a sector such as ours, machines will
be hard-pressed to have the same impact as they will on
other industries that will see wholesale dramatic change
(think self-driving truck and taxi services).
Why is that? Forecasting real estate demand and trends
involves variables (including human behavior and preferences),
that are many, and often unpredictable. Machines require
CRE Finance World Summer 2017
26
DISRUPTION
David Nabwangu
Founder
AI-Spark
Dr. Vince Gerbasi
massive amounts of data for problems that are this hard, which
will not practically become available (even in the long term).
That doesnt mean AI wont be a tool used in commercial
real estate, in fact it can help people become more accurate
and efficient. Lets review a little about the origin of AI
and its strengths and weaknesses as an analytical tool in
todays CRE industry.
Background
Behind all of these exciting, and at times frightening innovations
lies the discipline of machine learning.
Machine learning is the science of enabling computers to
learn without explicit direction, to form their own logic, and
learn from new experience. The field is an inter-disciplinary
amalgamation of methods, both old and new.
Its roots are founded in common statistical techniques
uncovered and developed in the 18th and 19th centuries,
including the work of Thomas Bayes (17011761), and
Andrey Markov (18561922).
The 1950s saw the first machines that attempted to mimic
human learning. IBM produced machines that could play
checkers and learn from past experience.
In 1967 the algorithm of the Nearest Neighbor (see Quick
Reading Suggestions) was created, which remains at the
root of many clustering techniques today.
Machines can be trained
to recognize nuances
and inform humans
about on-going changes
in correlations between
and within clusters.
 CRE Finance World EVOLUTION CHANGE DISRUPTION

By the 1990s machine learning began to leverage data and This grouping could be done with any characteristic. Multiple
data science; IBMs Deep Blue beat the world champion of ways of cutting the data expose a similar dynamic, where
chess in 1997. defaults rates are often elevated in a subset of clusters.
Today, two things are happening that contribute to a renais- #2 Clusters correlate
sance in the importance of machine learning: (i) affordable Clusters correlate in two different ways that play into the
computing power dramatically increased in the past three hands of machine learning algorithms. First, they sub-stratify
decades (Moores Law suggests that this rapid rate of and correlate with each other (for example oil towns across
increase may continue), (ii) large data sets became openly Oklahoma and North Dakota are highly correlated).
available to academics and data scientists permitting them
Second, they correlate across time: A change in performance
to develop, refine, and test mathematical and computational
(well call it a spark) in a given cluster can increase the
algorithms.
likelihood of a spark in that cluster in the future.
Machine Learning in the CRE Industry
Additionally, correlations among properties in a cluster,
There are a number of aspects peculiar to CRE data that
or between different clusters, can be intricate and non-
lend themselves to machine learning methods.
linear a reality which lends itself to machine learning
#1 Risks Cluster solutions. Consider the performance of office properties in
CRE credit risk analysis involves the seemingly endless task tertiary areas (where they struggle), vs. industrial properties
of identification, and evaluation of the impact of performance in tertiary areas (where they thrive), or the performance of a
clusters. Whether it is identifying all loans impacted by multifamily properties with low DSCRs (which is a norm) vs.
JCPenney, Macys and Sears store closings, or forest fires in hotels with low DSCRs (many times indicative of distress).
Santa Rosa, California or Fort McMurray, Canada. Analysis
Machines can be trained to recognize nuances and inform
of clusters function as critical harbingers of CRE trends.
humans about on-going changes in correlations between
Many machine learning algorithms are dedicated to cluster- and within clusters.
ing analysis. For example a Machine Learning algorithm
#3 Risk metrics change
developed in the 90s by Michael Eissen and colleagues is
Risk metrics are never static in their impact on CRE collateral
used by scientists to analyze the expression of genes from
and CMBS bond performance. Over time, they change
yeast. In the case of yeast gene expression data, genes
(sometimes dramatically). This is starkly illustrated by
that consistently change their expression under specific
the migration of historical frequency of default curves
conditions cluster together. In the case of CMBS data
depicted below.
clustering highlights properties, loans and bonds that follow
similar performance trends. Exhibit 2
In fact, the CRE market as a whole can be represented as
the sum total of its clusters: The chart below expresses
newly special serviced loans in a 2-year window broken
out into clusters (Dimensions). The dimensions are groups
of loans that share a similar property type, zip code, largest
tenant, city and/or state. Of note are the clusters with
elevated default activity (properties where Staples is the
largest tenant, and properties located in oil industry zip codes
and cities). Of interest as well are some of the clusters that
are not represented below: those with the lowest default
rates in the time period such as clusters of loans in Toronto,
San Francisco, and/or Mobile Housing properties.
Exhibit 1
Spark Clustering

CRE Finance World Summer 2017

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 CRE Finance World EVOLUTION CHANGE
The curves map reported trends in delinquency against
DSCRs from 1997 through to 2016. The curves react to
the dotcom bubble, the Great Recession, and the struggles
of highly levered loans in todays refinancing environment,
increasing and subsiding through time.
Machines can be trained to acknowledge these patterns
and actively track and recalibrate models to reflect both
long-standing trends, and the memory of short-term events.
Limitations
If you look at each of the major advancements and applications
of machine learning technology in our lives, there is often a
common thread: Machines have done very well when there
is a strict (or limited) set of rules to follow or interpret, AND
where there are massive amounts of data to learn from.
Credit risk in CRE is different. It is a harder problem in that
it has a very large number of risk factors that can affect
collateral or bond performance, and, perhaps just millions1
(as opposed to billions) of rows of accessible information
for a machine to learn from. The often cited curse of
dimensionality first mentioned by Richard Bellman in the
1950s stipulates that for each additional characteristic,
the machine needs an exponential amount more data to
learn from.
In Chess, there are an expressly limited number of moves
that each player can make at any given time. And there are
billions of rows of data available from which machines can
learn. In logistics, robots have set paths they can follow, and
a set number of shelves and packages of merchandise to
search, along with billions of transactions taking place that
they can learn from. Even self-driving cars are limited by the
roads that they must travel, as well as the rules of the road,
and they are helped by decades of car driving experience
and data.
Any application of machine learning algorithms for credit
risk analysis requires domain knowledge to circumvent the
difficulties posed by this problem.
Machine Learning in credit risk analysis succeeds when it
helps people become more accurate and efficient.
Conclusion
Evaluators of CMBS risk know these dynamics first hand.
We are aware of risk clusters and their effect on portfolios,
we are aware that these risks change through time, and
keep our minds occupied with trying to quantify their effects.
Many of the performance sparks in CRE data today will
prove to be harbingers of bond losses in the future.
Given the high dimensionality of credit risk (and the relative
scarcity of data); machines need to be trained and supervised
CRE Finance World Summer 2017
28
DISRUPTION
by humans with the proper domain knowledge. But the
rewards of applying machine learning algorithms to CRE
credit risk are
many; humans can
train machines Given the high dimensionality of credit
to constantly and
consistently fol- risk, machines need to be trained and
low the data, and supervised by humans with the proper
recalibrate their
measurements of domain knowledge.
risk while they
get more sleep.
Quick Reading suggestions
For more information on the exciting and fast growing field
of Machine Learning here are some suggested readings:
The Impact of Technology on Jobs in the US: The Myth and
the Reality of Manufacturing in America, Michael J. Hucks,
PhD, and Srikant Devarag
Introduction to Nearest Neighbor Analysis: https://www.
analyticsvidhya.com/blog/2014/10/introduction-k-neigh-
bours-algorithm-clustering/
Automation in Logistics, Kiva Robot: https://www.youtube.
com/watch?v=8gy5tYVR-28
Moores Law: http://www.mooreslaw.org/
Self-Driving Trucks: https://www.trucks.com/2017/02/16/
deep-learning-self-driving-truck/
https://www.wired.com/2016/10/ubers-self-driving-truck-
makes-first-delivery-50000-beers/
The Authors
David Nabwangu is an experienced researcher, quantitative risk
modeler, and founder of AI-Spark. David was previously head of
CMBS research at a leading rating agency where he developed
methodologies, credit risk models, and risk analytic systems used
across Europe, Canada and the United States.
Dr. Vince Gerbasi is a cross-disciplinary researcher with experience
in analyzing and comparing large datasets using clustering algorithms.
Vince received his PhD from Vanderbilt University Medical School
and performed his postdoctoral studies at Northwestern University.
His past research used state of the art biochemical, genomic and
computer science approaches to tackle some of the most difficult
problems in biology and medicine including infectious disease
outbreaks and vaccine development.
Data Sources
Data for this article was provided by CMBS.com and AI-Spark
1 The CREFC Investor Reporting Package provides approximately
20 million rows of loan level historical data as of Q2 2017
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commercial mortgage backed Capital markets distribution
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expedient and attractively priced mortgage servicing Trust services
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CRE Finance World

Retail Store
Closing Fiction Joseph Ori
Executive Managing Director
Paramount Capital
Corporation

Many Wall Street and CRE pundits have declared that malls
and shopping centers are dead. The brick and mortar stores
will be relics in 20 years. Amazons online business will dis-
intermediate them out of business and consumer shopping
habits have changed forever. There have also been weak
first quarter earnings reports from many retailers including;
JCPenney, Sears/Kmart, Kohls, Macys and others. These
retailers and many others have been on a store closing
binge that the experts claim is the final nail in the shopping
center store coffin.
Retailers that experience tough business conditions do not
represent the entire retail industry. Walmart, the various
dollar stores and home improvement retailers have been
doing just fine. Most of the retail earnings softness is due
to poor management decisions regarding inventories, store
expansion, purchasing programs, sloppy general business
operations and a stingy consumer. In addition, the rosy
economy and 4.6% unemployment rate are a mirage. The
economy is not doing well for the average American and
the real unemployment rate is around 15%. The labor
participation rate is at a 40 year low
of 62% and there are more than 95
Companies that fail to provide an million people out of the labor force.
Increased minimum wage rates in many
enticing and seamless experience cities have also contributed to higher
will struggle and potentially close costs and lower profits in the retail and
restaurant industries. Most of the new
their doors. jobs created during the last eight years
have been low wage part-time service
jobs. Obamacare has also been a big job killer, by converting
many full-time jobs to part-time to escape the employer
health cost mandate. The sky rocketing and unaffordable
premiums for many under Obamacare have also lowered
the average consumers disposable income, which cannot
be spent on goods and services. Obamacare has been one

CRE Finance World Summer 2017

30
CRE Finance World Summer 2017 Volume 19 No. 2

of the biggest killers of consumer retail demand since the Another interesting analysis regarding the tumultuous
introduction of the income tax.1 All of these factors are retail industry, is the number of retail companies that have
the real reasons the retail business is hurting and its not gone bankrupt. Listed in the table below, are some of the
Amazon or the Internet. Online shopping sales are only largest retail bankruptcies in 2008 and 2016. This is not
about 8% of total retail sales and will never account for an all-inclusive list, but still illustrates the large number of
a large majority of sales. Most individuals still prefer the retail bankruptcies in any year and further evidence of the
in-store shopping engagement and experience. creative destruction in our capitalistic economy. As stated
above, retailers open new stores when the economy is
To be a successful retailer today, a company must offer
good and close stores when the economy declines. This
attractive goods or services at a competitive price and, most
is the normal function of a competitive market and when
importantly, an enticing and seamless shopping experience
companies do not perform to the expectation of customers
over three platforms, brick and mortar, internet and mobile.
and investors, they usually go out of business.
Companies that offer this experience will continue to grow
and generate increasing sales and profits. Just look at Apple
Stores, Nordstrom, Total Wine and Best Buy as examples. 2008 Retailer Bankruptcies 2016 Retailer Bankruptcies
Companies that fail to provide an enticing and seamless Circuit City Sports Authority
experience will struggle and potentially close their doors. Linens n Things Aeropostale
One of the main statistics claimed by the pundits, when Friedman Jewelers Sports Chalet
declaring that malls and the retail markets are dead, is the Whitehall Jewelers Bobs Stores
large number of store closings. Retail store closings are a
natural occurrence in the retail industry. When economic Fortunoff Pacific Sunwear
times are good, retailers are optimistic and flush with cash Fred Leighton Wet Seal
and expand aggressively. However, when the economy Goody
softens or enters a recession retailers contract and close
stores. Even if the economy is solid, some retailers Mervyns
through poor merchandising, management and expansion Sharper Image
policies experience difficult financial results and therefore Wickes Furniture
need to cut costs. The easiest place to reduce expenses is
to close underperforming and marginally profitable stores.
Retail store closings are a natural part of the ebb and flow We here at View of the Market believe that the Wall Street
of the retail industry. pundits are wrong about the decimation of brick and mortar
stores and the retail industry.
We here at View of the Market have looked back at store
1 http://www.zerohedge.com/news/2016-12-23/top-white-
closings in 2008 and in 2016, to see if there are more store
house-economist-admits-94-all-new-jobs-under-obama-were-
closings today than there were 10 years ago. The table below
part-time; https://www.advisorperspectives.com/commentar-
shows equivalent store closings in 2008, per Retail Info
ies/2016/10/17/taking-a-wrench-to-healthcare
Systems News, and in 2016 per the retail industry.

2008 2016
Retailer Store Retailer Store
Closings Closings
Circuit City 150 Sports Authority 460
99 Cent Stores 48 Walmart 269
Disney 98 Aeropostale 154
Ann Taylor 117 Kmart/Sears 78
B Moss Clothing 70 Ralph Lauren 50
Barbeques Galore 65 Chicos 120
Pacific Sunwear 153 Hancock Fabrics 255
KB Toys 460 Macys 100
Linens n Things 120 Mens Ware- 250
house/Jos Bank
Goodyear Tire 92 Office Depot 400
Friedmans 120 Wolverine 100
Jewelers Worldwide
Sharper Image 90 Walgreens 200
Zales 100
Talbot Kids 78
GAP 85

CRE Finance World Summer 2017

31
CRE Finance World
A Sherpa for CMBS Borrowers
The Value Proposition of
Debt-Resolution Advisors
Loan advisory services date back to the beginnings of
the CMBS industry, but the sheer volume and complexity
of restructuring troubled loans in the wake of the 2008
financial crisis have created significant demand for firms
to fill that role.
Some borrowers with loans in CMBS need guidance to
maneuver through the complex requirements embedded
in securitization documentation. As such, Morningstar
Credit Ratings, LLC believes that qualified and reputable
companies can assist in educating borrowers less familiar
with CMBS requirements.
There are two types of commercial debt-resolution advisors.
Both handle sophisticated and institutional borrowers with
complex and high-profile properties serving as collateral
for large loans, which could involve hundreds of millions
of dollars. One type of advisory company, which deals
solely with these sophisticated borrowers, is typically run
by former commercial lending and asset-management
professionals with experience in both the debt and equity
sectors. Another type also administers to borrowers with
much smaller balance loans and plain-vanilla collateral.
These investors are typically unaware of the requirements
for administration of the pooling and servicing agreements
(PSAs) governing these CMBS loan pools. Debt-resolution
mediators can provide these borrowers guidance on consent
requests, most notably assumptions, which was particularly
valuable during the early stages of the financial crisis. These
intermediaries are now assisting those borrowers in working
out their troubled loans upon their transfer to a special
servicer. This commentary will focus on those businesses
that deal with both sophisticated and less-experienced
borrowers with smaller balances.
To gauge the effect commercial debt-resolution advisors
have had, Morningstar Credit Ratings, LLC reached out
to executives at six of the largest or most active special
servicers in CMBS, including Midland Loan Services, a
division of PNC Financial Services Group, Inc.; Torchlight
Loan Services, LLC; and Situs Holdings, LLC for feedback
on their experience with these companies. Others willingly
spoke with Morningstar, but requested that their names
CRE Finance World Summer 2017
32
Michael G. Gutierrez
Managing Director,
Operational Risk Assessments
Morningstar Credit
Ratings, LLC
not be used. In addition to observations about the impact
of these companies actions on defaulted loans, we sought
to determine what common characteristics, if any, clients
of these advisory companies share, especially in terms of
unpaid principal loan balances and property types.
From the Special Servicers Viewpoint
The majority of special servicers reported a positive experi-
ence working with commercial debt-resolution mediators,
although most had one caveat: namely, that the experience
depended on the company involved. Certain intermediaries
made a difference in the quality of the borrower experience,
while others were less effective. Some servicers cited cases
where they believed an advisor hindered the process by
repeatedly objecting to reasonable resolution offers. In
addition, special servicers reported certain companies, which
they didnt name, that did little or nothing on borrowers
behalf and in their opinion were simply interested in collecting
an upfront fee. This is, unfortunately, not uncommon in
many consulting industries, especially in their infancy, and
has been widely reported in the general press with regard
to mortgage modification and foreclosure consultants in
the residential market, for example. This also may indicate
the lack of sophistication of some CMBS borrowers served
by this industry. Some servicers on their own initiative
have taken steps to address borrowers concerns. Midland,
for instance, established an ombudsman who borrowers
with unsolved issues or requests may contact directly.
According to most of the special-servicing companies we
spoke with, the typical borrower engaging a commercial
debt-resolution advisor has an unpaid principal loan balance
of between $5 million and $25 million, with a few pegging
the usual upper limit at $15 million. (As of late February, the
average size of all loans in the Morningstar CMBS database
was $11.5 million.) Property types are concentrated in the
office and retail sectors. Borrower advisors likely will have
a lot of work this year, given the maturity pipeline. In our
February remittance Maturity Report, Morningstar reported
that some $56.40 billion of CMBS loans will mature this
year, and many, written at the markets peak in 2007, will
have difficulty refinancing because they are overleveraged.
Of the maturing balance, $18.64 billion are backed by
CRE Finance World
office properties; office has the greatest balance of loans at
33.1% of the maturing balance. Morningstar projects 58.4%
of maturing loans backed by office collateral will have trouble
paying off because of loan-to-value ratios above 80%, which
we consider a reliable barometer of refinancing prospects.
Meanwhile, we project 56.7% of maturing loans backed
by retail properties will have refinancing woes. (Retail is
second-highest with $17.91 billion of maturing retail loans,
or 31.8% of the total maturing loan balance.)
A common theme among these special-servicing executives
is the important role played by these advisory companies in
educating borrowers on the requirements and restrictions in
CMBS transactions.
A CMBS borrower advocate helps A number of special
servicers expressed
level that playing field by providing relief in having the
advisor take on this
the borrower with insight into the time-consuming task,
inner workings of CMBS. because tutoring a
borrower regarding
what can and cannot
be done under a particular PSA interferes with the special
servicers goal of achieving an expeditious resolution of a
defaulted loan at the best return possible to the trust and its
investors. While a few executives believed that commercial
debt-resolution advisors added little or no value to the
default-resolution process, most opined that while education
of the borrower was important, the end result for the borrower
differed little because of the advisory companys intervention.
They based this opinion on their belief that it is primarily the
underlying value of the property, its cash flow capabilities,
and the access to equity capital by the borrower that
determine the resolution outcome. Morningstar believes
that commercial debt-resolution advisors play an important
role in persuading the borrower that the realities of the
propertys income-generation capability and the borrowers
ability to provide any equity infusion make a particular
outcome accepted by the special servicer the borrowers
best, and perhaps only, choice.
From the Borrower Advocates Viewpoint
Morningstar spoke with executives of two commercial debt-
resolution advisory businesses: Grapevine, Texas-based
1st Service Solutions, Inc. and Hart Advisors Group, LLC of
Dallas. Both consider the vetting process they undertake
before engaging any borrower clients to be a key element
of their strategy. First, the companies gauge the level of
understanding borrowers have regarding requirements of
CMBS transactions. Agreeing with the special servicers that
emphasized the importance of borrower education, they
pointed out the need to ascertain whether the borrower
Summer 2017 Volume 19 No. 2
would heed their counsel. Ann Hambly, founder and CEO of
1st Service Solutions, stated that the company rejects over
50% of potential clients because of this process. While
this might seem counterproductive to business growth, it
increases efficiency by letting asset managers focus on
borrowers with a higher chance for successful resolutions.
In the interest of full disclosure, Morningstar, which provides
operational risk assessment rankings on commercial
vendors, has assessed 1st Service Solutions at its second-
highest ranking, MOR-CV2, as a debt-resolution advisor.
Morningstar identified another potential benefit these busi-
nesses offer: equity capital sourcing for borrowers in need
of cash for their properties. Both companies we spoke with
confirmed that they have relationships with brokers and
other sources of capital that they could refer borrowers to
when, as is often the case, the special servicer requires a
capital infusion as part of any restructure negotiation. While
the debt-resolution advisors themselves do not invest in the
asset or engage in lending, this can provide an important
service to borrowers who lack the contacts to procure funding.
In an email, Tanya Little, CEO and founder of Hart Advisors,
wrote the company formed a subsidiary to focus on sourcing
debt and equity in 2014 after realizing that its clients lacked
sufficient levels of capital and liquidity to close on deals.
Little wrote that the service gives clients confidence that
Hart Advisors will place them in a position to execute on a
resolution strategy.
Executives from the advisory companies added they play a
helpful role in the loan-resolution process. In an email, 1st
Service Solutions Hambly noted that given the structure
of CMBS, when a borrower may not be able to speak with
decision makers, that the playing field is heavily tilted in
favor of the lender. A CMBS borrower advocate helps level
that playing field, she wrote, by providing the borrower with
insight into the inner workings of CMBS.
There are, however, some companies claiming to be debt-
resolution advisors that have little asset-management
experience and serve only to close loans. According to the
special servicers we spoke with, this type of business can
be detrimental to a successful loan disposition.
Assessing Commercial Debt-Resolution Advisors:
Operational Best Practices
Morningstar applies its traditional standards for assessing
operational risk when examining commercial debt-resolution
advisors. These include organizational structure, technology
architecture, and a strong quality-control regimen. We look
for well-documented policies and procedures with an authority
matrix for revisions or additions. We scrutinize turnover rates
for management and staff as well as employee training.
CRE Finance World Summer 2017
33
CRE Finance World
We also consider industry experience, particularly in lender
workouts and CMBS asset management, and company tenure
for all employees, although tenure is less of a factor in
such a nascent industry. Morningstar looks for commercial
debt-advisory companies to follow an established protocol
for reviewing each assets performance and critical issues
to propose reasonable resolution terms that are acceptable
to the special servicer and can deliver an optimal outcome
for the trust. We believe companies should formalize such
analysis in an asset action plan and approve it by a credit
committee or delegated authority matrix, depending upon
loan size and asset complexity.
The Bottom Line: Guiding Borrowers Through the
Next Mountain of Default
It is difficult to gauge the impact of commercial debt-resolution
advisory businesses. Special servicers asset-management
systems typically are not programmed to create reports
filtered by the variable of a borrowers use of an intermediary,
as such information would be in the commentary section
of the loan record or asset action plan. There is little public
information on this topic other than what would be noted in
servicer comments on monthly trustee reports. However,
based on Morningstars discussions with special-servicing
and commercial debt-advisory professionals, we believe that
value can be gleaned from the participation of qualified and
reputable advisory companies in the resolution of certain
types of loans involving borrowers less familiar with CMBS
requirements. Accordingly, Morningstar believes there will
be a role for advisory companies in the resolution of certain
distressed CMBS loans, particularly this year when billions
of dollars worth of loans written at the height of the market
will mature.
CRE Finance World Summer 2017
34
DISCLAIMER
The content and analysis contained herein are solely statements of
opinion and not statements of fact, legal advice or recommendations
to purchase, hold, or sell any securities or make any other investment
decisions. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE
ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY
OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY
SUCH RATING OR OTHER OPINION OR INFORMATION IS
GIVEN OR MADE BY MORNINGSTAR IN ANY FORM OR
MANNER WHATSOEVER.
To reprint, translate, or use the data or information other than as
provided herein, contact Vanessa Sussman (+1 646 560-4541)
or by email to: vanessa.sussman@morningstar.com.
2017 Morningstar Credit Ratings, LLC. All Rights Reserved.
Morningstar Credit Ratings, LLC is a wholly owned subsidiary of
Morningstar, Inc. and is registered with the U.S. Securities and
Exchange Commission as a nationally recognized statistical rating
organization (NRSRO). Morningstar and the Morningstar logo are
either trademarks or service marks of Morningstar, Inc.
Michael G. Gutierrez is managing director of operational risk
assessments for Morningstar Credit Ratings, LLC. He manages
a team of experienced operational risk professionals and is
responsible for the operational risk assessment reports and
related rankings for each participant analyzed by Morningstar.
Gutierrez holds a bachelors degree in political science from Williams
College and a juris doctor degree from Columbia University School
of Law.
 Whats going on at
CREFC Europe?

3-5 July 6 July

Member Only
Executive Education Programme
Summer BBQ
Contact Rachel
Contact Carol
rsmith@crefceurope.org
cwilkie@crefceurope.org

11 July
After Work Seminar
Host: Paul Hastings 13 July
Non-Performing Loan Refinancing YPREF Networking Drinks
Lending Opportunities behind Contact Rachel
the NPL Wave rsmith@crefceurope.org
Contact Carol
cwilkie@crefceurope.org

12 September CREFC Europe

Autumn Conference
Morning Seminar
Host: Allen & Overy LLP 14 & 15 November
Lending in Europe Secure your place as a sponsor
Registration to open mid-July Be an early bird and register in June
Contact Carol Contact Carol
cwilkie@crefceurope.org cwilkie@crefceurope.org
CRE Finance World
A Rising Tide Lifts
All LIBOR Loans
The Case for Investing in
Floating-Rate CMBS Now
U.S. interest rates are on the rise. In March 2017, the
Federal Open Market Committee (FOMC) voted to raise
interest rates for only the third time in a decade, increasing
the federal funds target range by 25 basis points to
0.75%1.00% based upon, the economys continued
progress toward the employment and price-stability objectives
assigned to us [the FOMC] by law. Having awoken from its
slumber since 2009, interest rates across the board from
Treasuries to LIBOR are increasing with estimates of two-
to-three increases by year-end 2017. Increasing rates will
impact CMBS investors in several regards, including loan
coupons, fair-market-value (FMV), debt-service-coverage
ratios (DSCR), loan-to-value (LTV) to the extent that rising
interest rates impact property values, and total returns.
In a rising interest rate environment, we believe that a tactical
shift into floating-rate CMBS can enhance an investors
returns both offensively, through increasing monthly coupons,
and defensively, by reducing FMV loss exposure due to
decreases in value solely related to increased Treasury
yields. This paper will examine the floating-rate CMBS
universe, how floating-rate CMBS work and the risks and
benefits of a floating-rate CMBS focused strategy.
Chart 1
The Federal Funds Rate 2003 to 2017
Source: Federal Reserve
CRE Finance World Summer 2017
36
Edward Shugrue
Talmage
Chart 2
Three Year Forward LIBOR Curve (April 2017)
Source: Bloomberg
The Floating-Rate CMBS Universe
The floating-rate CMBS universe consists of approximately
$72 billion of outstanding transactions accounting for
approximately 13% of the entire CMBS universe and includes:
Single Asset/Single Borrower (SASB) transactions, pooled
floating-rate loans, CRE CLOs (typically securitizations of
first mortgages), and loans secured by multi-family properties
issued by Freddie Mac. While not packaged as CMBS,
floating-rate commercial real estate debt can also be
found in the whole loan market, the mezzanine loan market
(particularly in SASB transactions) and, to a lesser degree,
in the bank loan market, which together add $30+ billion of
additional floating-rate inventory.
Floating-rate loans continue to be a popular source of funds
for borrowers, particularly private equity sponsors, for large
and more transitional assets due to a lower current coupon,
typically interest-only, and the lack of (or substantially more
modest) prepayment penalties. The transition element
for the property, or the portfolio of properties, is often a
wholesale to retail rationalization of a portfolio of recently
acquired properties, as was the case with Blackstones
$3.5 billion 2013 Hilton transaction HILT 2013-HLT (which
included both floating and fixed-rate components) and
which spawned subsequent fixed-rate transactions for the
retained portfolio, such as the Hilton San Francisco HILT
2016-SFP. Transitions can also occur at the property level,
as was the case for Blackstones Willis Tower financing
in March 2017 where the borrower used the floating-rate
financing to improve and stabilize the assets cash flow before
seeking longer-term and potentially fixed-rate financing.
CRE Finance World Summer 2017 Volume 19 No. 2

Chart 3
Willis Tower Capital Structure ($000s except PSF data)
Credit Loan NOI NCF
Class Rating Loan Amount Support Coupon LTV PSF Yield DSCR
A AAA $506,628 50% L+0.80% 33% $131 18% 10x
B AA- 112,584 39% L+1.10% 41% 160 15% 4x
C A- 84,438 31% L+1.25% 46% 182 13% 4x
D BBB- 103,577 21% L+2.25% 53% 209 11% 4x
E BB 140,730 7% L+3.30% 62% 246 9% 3x
F BB- 20,688 5% L+4.10% 64% 251 9% 3x
HRR B+ 51,355 0% L+5.50% 67% 264 9% 2x
Total $1,020,000
Source: Commercial Mortgage Alert

Floating-rate loans typically have a five-year term but can
be as long as seven years. The loans are typically open to
prepayment (on the loans monthly remittance date) and
often have limited call protection.
How Floating-Rate Loans Work
Floating-rate loans offer borrowers flexible financing that is
typically of a shorter term and open to prepayment without
penalty. For loans that are intended to be held for less than
three years, they can also offer a lower all-in financing
cost due to the favorable difference between one-month
LIBOR and US Treasury rates, assuming equal credit
spreads for comparable borrowing amounts. One-month
LIBOR is the most frequently used index for floating-rate
CMBS loans (as opposed to three-month LIBOR for many
bank loans) and the borrower is responsible for paying on a
monthly basis the index (one-month LIBOR) plus the loans
credit spread. Each month the index is reset, higher or
lower, depending upon prevailing LIBOR rates. As illustrated
below, since the Financial Crisis, one-month LIBOR has
been below 50 basis points and has only recently started
to climb.
Chart 4
Historical LIBOR 20032017
Source: Bloomberg
Unlike many bank loans that contain LIBOR floors (recently,
typically 1%), most floating-rate CMBS have no floors.
All floating-rate CMBS loans do require the borrowers to
purchase interest rate caps that are assigned to the CMBS
trust and which are written to a minimum debt service
coverage ratio based upon in-place cash flow. While these
caps limit the borrowers debt service burden in a rising
rate environment, the benefit (from the rate protection) is
passed along to the CMBS bond buyers who have unlimited
LIBOR upside. Importantly, and to reduce up-front expenses,
a typical five-year floating-rate CMBS loan will be written
with an initial term of two or three years with successive
one-year extension options (to full term) conditioned only
upon there being no event of default and the borrower
purchasing additional interest rate protection for the next
period. Additionally, floating-rate CMBS loans are typically
open to prepayment without penalty, often resulting in a
shorter actual duration than the contractual maturity.
Benefits and Risks of a Floating-Rate
Investment Strategy
Floating-rate CMBS offer investors several benefits but also
carry certain risks as compared to investing in longer-dated
fixed-rate CMBS with call protection.
We believe that the primary benefits of a floating-rate
CMBS strategy are:
O
 ften acquisition financing with excellent alignment and
identifiable sponsor equity;
T
 ypically larger, institutional-quality, SASB transactions;
E
 liminates the risk of FMV erosion should interest
rates rise;
A
 llows the investor to capture upside (through the LIBOR
index) should LIBOR increase;
T
 ypically shorter duration; and
M
 ore conservative loan-to value attachment points (due to
lack of diversity) as compared to a comparably rated (and
diversified) conduit transaction.

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Chart 5
Floating-Rate vs. Fixed-Rate Capital Structure Analysis 1
Rating Floating-Rate LTV Fixed-Rate LTV
AAA 33%
AA 41%
A 46%
BBB 53%
1 Capital structures and metrics taken from representative 2017 CMBS SASB and
conduit transactions.
We believe that the primary risks of a floating-rate CMBS
strategy are:
Limited or no call protection;
Lack of certainty on duration (difficult to match up
with liabilities);
Concentrated credit (often SASB); and
Declining debt-service coverage (up to the cap) in a
rising interest rate environment.
We believe that floating-rate CMBS offer investors a more
pure alpha credit strategy as opposed to a rates driven
strategy that also allows investors to capture upside should
LIBOR continue to increase, as appears to be likely for
the foreseeable future, given the current environment.
Floating-rate loans also offer a typically shorter duration
and an emphasis on CMBS SASB transactions that are
better suited to individual asset due diligence than a typical
conduit transaction.
Conclusion
With interest rates finally moving upward, nearly ten years
following the financial crisis in 2008, floating-rate CMBS
offer a compelling way to capture upside (should LIBOR
continue to increase) and to better manage risk. Floating-
rate CMBS maintain value as opposed to losing value when
Treasury rates rise, as shown in the chart below.
CRE Finance World Summer 2017
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Chart 6
CMBS Conduit Valuation Changes Due to Treasury Increases1
Treasury Increase Value Change
(bps) (%)
41%
T+50 -4%
48%
T+100 -8%
51%
T+150 -11%
54%
T+200 -15%
T+250 -18%
1 Utilizing Bloomberg pricing models and a $1 billion 2017 ten-year new issue conduit
transaction at constant spread and 0% CPY.
Floating-rate CMBS are helpful from a risk management
perspective due to their shorter duration (less tail risk)
and typically greater subordination levels (debt and equity)
as compared to typical conduit transactions. Additionally,
since the majority of floating-rate loans are used to finance
acquisitions and/or assets in some form of transition,
sponsor equity is typically contributed at closing and the
alignment of interests between lender and borrower is
well established. While floating-rate CMBS may be more
difficult to perfectly match an asset/liability balance, for total
return investors willing to perform the extra due diligence,
in todays environment, they offer compelling upside in a
comparatively conservative structure. Floating-rate CMBS
also help better define a managers true alpha generation
from credit selection as opposed to returns that can be
whipsawed, positively or negatively, by changing interest rates.
All-in, floating-rate CMBS offer compelling total returns for
investors in todays increasing interest rate environment.
Edward L. Shugrue III is the CEO of Talmage, LLC. Talmage is a
New York based investment manager and special servicer focused
on the US commercial real estate debt and CMBS markets. Since
2003, Talmage has made in excess of $12 billion of real estate
debt investments and has completed over $40 billion of special
servicing assignments. More can be learned at talmagellc.com.
CRE Finance World
CMBS Conduit Q1 2017 Update:
Retail Exposure Declined
While Full Term IOs and Office
Concentrations Rose Sharply
In the first quarter of 2017, S&P Global Ratings observed
some quarter-over-quarter improvement in loan leverage,
diversity metrics, and lodging exposure. However, those
improvements were offset by a sharp rise in full-term IO
concentrations. As such, our required CE levels on reviewed
pools remained consistent, and on average, remain about
200 basis points (bps) higher compared to priced deals. In
terms of property type trends, amid heightened investor/
media focus, retail exposures in collateral pools fell sharply
in the first quarter, while office concentrations increased
significantly to nearly 50% on average. We believe that
specific property concentration creates fundamental exposure
risks as one property type comes into favor and another
moves out of favor. Our rating methodology for conduit/
fusion transactions assumes that collateral pools are
diversified not only by loan count, borrower, and geography,
but also by property type.
Some Loan Metrics Improved In The First Quarter,
But Not Full-Term IOs
Compared with fourth-quarter 2016, the nine new collateral
pools S&P Global Ratings reviewed in first-quarter 2017
had lower leverage (90.6% in first-quarter 2017 versus
92.5% in fourth-quarter 2016). We attribute this mostly to
the onset of U.S. risk
retention regulations for
Specific property concentration CMBS in late 2016.
creates fundamental exposure First-quarter 2017
pools also maintained
risks as one property type comes fairly consistent debt
into favor and another moves service coverage (DSC)
ratios (1.72x versus
out of favor. 1.75x), lower exposures
to lodging properties
(14.3% versus 15.8%), and modestly higher final effective
loan counts (Herfindahl scores). Focusing in on the effective
loan counts, the gap between preliminary and final pools
Summer 2017 Volume 19 No. 2
James C. Digney James M. Manzi, CFA
Senior Director Senior Director
S&P Global Ratings S&P Global Ratings
closed significantly, but remains somewhat wide. In our
view, less diverse pools accentuate credit risk, especially
if the loans are higher leverage, as a few large loan
defaults may create investment-grade principal losses
or interest shortfalls.
One metric that deteriorated significantly during the most
recent quarter was full-term IO exposure, with a concentration
of 42% in pools we reviewed in the first quarter, up from
30% in fourth-quarter 2016. In fact, the final pool full-term
IO concentrations for first-quarter 2017 and fourth-quarter
2016 were even higher at 46% and 36%, respectively,
indicating that full-term IO concentrations are actually rising
from preliminary to final pools. We penalize full-term IOs in
our model with lower recovery assumptions, as the lower
payments during the loan term somewhat reduce term
default risk, but the lack of amortization raises maturity/
balloon refinancing risk considerably.
Given the overall movement in credit metrics, our average
required CE levels remained mostly unchanged. S&P Global
Ratings average AAA CE levels increased very slightly to
24.8% in first-quarter 2017 from 24.6% in the fourth quarter,
and average BBB- CE levels increased to 10.0% from 9.9%.
Although similar to the fourth quarter, both CE levels remain
higher than the prevailing average CE levels in the market
(22.5% for AAA and 7.5% for BBB- in the first quarter),
which resulted in S&P Global Ratings being requested to
assign ratings to only two of the nine transactions reviewed
during the first quarter. In our view, the two rated transactions
had significantly lower leverage (86.6%) than the seven
unrated transactions (91.4%).
These metrics encompass both rated and unrated trans
actions. For the unrated transactions, the metrics reflect
the preliminary collateral pools presented to us by issuers.
The actual or final pool metrics cover the pool compositions
upon pricing.
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Table 1
Summary of S&P Global Ratings-Reviewed Conduits
Weighted
averages 2013 2014 2016 (all) 2016 Q4 2017 Q1
No. of transactions reviewed 46 39 40 8 9
Average Deal Size ($mn) 1,181 1,170 856 860 962
Average Number of Loans 68 72 51 48 47
S&P Global Ratings LTV (%) 85.5 90 91.3 92.5 90.6
S&P Global Ratings DSC (x) 1.65 1.52 1.71 1.75 1.72
S&P Global Ratings beginning DY (%) 9.6 9 9 8.9 9.1
Final Pool Herf/S&P Global 24.2/29.6 27.7/32.7 25.4/36.0 25.1/40.3 25.7/33.1
Ratings Herf
% of lodging properties 15.7 15 17.3 15.8 14.3
% of full-term IO 14.3 17.2 28 29.7 41.9
% of partial IO 30.5 40.9 32.6 31.2 28.3
S&P Global Ratings NCF haircut (%) -7.6 -8.4 -10.8 -10.6 -11.9
S&P Global Ratings value variance (%) -24.3 -25.2 -32.1 -31.9 -33.3
AAA actual/S&P Global Ratings CE (%) (i) 21.7/22.8 23.6/26.0 23.0/25.6 23.1/24.6 22.5/24.8
BBB- actual/S&P Global Ratings CE (%) (i) 6.9/7.6 7.6/9.3 7.8/10.2 7.7/9.9 7.5/10.0
(i) S
 &P Global Ratings CE levels reflect results for pools that we reviewed. Actual CE levels represent every deal priced within a selected vintage, not just the ones we analyzed.
LTVLoan-to-value. DSCDebt service coverage. HERFHerfindahl score. DYDebt yield CECredit enhancement. IOInterest-only. NCFNet cash flow.

Retail Exposure Fell While Offices Increased
Heightened competition for retail sales from e-commerce
and industry peers has been squeezing profit margins and
lowering overall space demand for several years now; the
overall trend is not new. However, this years post-holiday
store closure figures (both the number of stores and
number of retailers) appear to be accelerating, and that,
combined with increased short interest in CMBS derivative
indices (CMBX), has led to a laser focus on the sector from
market participants. One consequence has been a sharp
decline in the percentage of retail exposure in collateral
pools. The first-quarter 2017 average was about 22%
compared with 35% in fourth-quarter 2016, and a 30%
average during full-year 2016.
Chart 1
Changing Property Type Composition
Apartment Industrial Lodging Office Retail Other
2016 10 6 16
Q4 8 5 14
2016
Q1 5 6 13
2017
In the early 2.0 vintages, retail was by far the highest
percentage exposure by property type, at 55% (2010), 45%
(2011), 36% (2012), and 32% (2013). While weakness
within the retail sector seems broad, we continue to stress
the importance of a loan-by-loan and deal-by-deal approach
to predict future outcomes for malls similar to what we
utilize in our new issuance/surveillance analyses as they
are likely to vary widely based on location, tenant mix, sales
per square foot, occupancy costs, co-tenancy clauses, and
many other variables.
A result of retail exposure avoidance is that office exposures
have climbed significantly, averaging nearly half of the
collateral pools in the first quarter. In fact, the 46% figure
is up sharply from 32% in fourth-quarter 2016, and the
29% full-year 2016 average. Additionally, recent conduit pools
have included a significant number of single-tenant office
assets, which present unique challenges in determining a
long-term sustainable cash flow and value for those properties.
Similar to our approach to retail assets, S&P Global Ratings
reviews these single-tenant properties on a loan-by-loan
basis, considering such things as location, tenant credit
profiles, lease terms, rent levels, dark/subleased space,
termination options, competing properties, and new supply
dynamics. In some instances where we see heightened risk
associated with a particular tenant, we may utilize a dark
value approach to account for downtime and any costs
associated with re-leasing the property.
Lastly, multifamily exposures in recent deals have been
29 30 9 lower, at just 5% in the first-quarter, while industrial
32 35 6 a property type buoyed by e-commerce has remained
at about 6%, equal to the 2016 average and up from 4%
46 22 8 in 2015.
In conclusion, we suggest that specific property concentration
creates fundamental exposure risks as one property type
comes into favor and another moves out of favor. Our rating
methodology for conduit/fusion transactions assumes
that collateral pools are diversified not only by loan count,
borrower, and geography, but also by property type. To the
extent we see an outsized portion of a pool concentrated
in one particular property type, we may make additional
qualitative adjustments to our credit enhancement levels
to account for this concentration risk.

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Cross Border Capital:
A Rear-View Mirror Only
Lets you Drive Backward
As in other recent market expansions, deals completed by
cross-border investors have been a signature feature of
the US commercial property market in the cyclic expansion
seen since the Global Financial Crisis (GFC). Is this growth
of cross-border capital a sign of impending doom for
commercial property prices?
Regulators are concerned about this capital coming to the
US in that cross-border investment was a signature feature
of the market expansion in the late 1980s and in the US
housing boom last decade. Much of the recent spotlight
has focused on Chinese investors in particular, along with
misguided comparisons to the experience of Japanese
investors in the US in the late 1980s or the Australians in
20052008.
In every expansion of the market cycle, there are features of
the market that echo with those seen in previous expansions.
However, it is a mistake to assume that history repeats itself
entirely. Looking at the expanding Chinese investment in US
commercial real estate only as a function of the behavior
and motivations exhibited by investors previously will miss
much of what motivates their activity today.
With this thought in mind the activity of the Chinese investors
is not a sign of doom to come for the US property market.
If they make mistakes it will not be the mistakes of the
Japanese, they will make their own, new mistakes.
What Drives Capital Flows?
There are any number of forces which might drive capital
to seek opportunities in commercial real estate in other
countries. Reform efforts for instance may tear down walls
closing off an economy from outside capital or remove
chaotic government policies which act as another sort of
wall scaring away capital. For the two previous big waves of
cross border capital that came to the US in recent memory
though, it was not about us, it was about them.
Forces external to the US economy drove cross border
capital to seek out opportunities here during these previous
big waves of investment. External forces that drive capital
flows are particularly worrisome to banking and financial
market regulators. Often, they will have no insight into the
Summer 2017 Volume 19 No. 2
Jim Costello
RC Analytics
external forces motivating these capital flows and no levers
with which they might control such flows.
In developing countries, there are often barriers to internal
and external capital flows to prevent wild price swings in
the domestic economy. The US by contrast has very open
and transparent investment markets and capital flows.
One challenge that regulators and market participants face
in understanding how these capital flows impact market
performance is that these flows are often pro-cyclical.
In other words, if there is bandwagon of capital moving into
a CRE sector, cross border capital is often a part of that
bandwagon. It is not clear however that this capital is ever
leading the bandwagon. These two big previous cycles
where cross-border money invested heavily in the US CRE
markets happened in periods of strong economic and price
growth. The experiences of these investors can provide
some perspective on ongoing activity by Chinese and other
global investors, but should not be used as a roadmap to
understand all their behavior.
External Forces in the Late 1980s
Japanese investment in the US real estate surged in the
period from 1985 to 1993 and the inflow and later outflow
of this capital exacerbated structural problems underway
in the US property market. The initial inflow however was
about changes in Japan. Betrand Renaud of the World
Bank argued that the Plaza Accords, which realigned the
exchange rates between the G7 countries, generated an
asset bubble in Japan which in turn led to excessive risk
taking overseas.1 Japanese investors in the late 1980s were
able to use over-valued Japanese land as collateral to obtain
bank loans which they then used to buy assets overseas.
For the Japanese investors, this trade provided marvelous
yield opportunities while land markets were still bubbly in
Japan. As land prices fell however and loans came due,
Japanese investors scrambled to sell US assets at discounted
prices to make good on promises back home. This inflow
of cross border capital quickly became an outward flood
which added fuel to the fire of a property market downcycle
fueled by excessive over construction in the US.
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There were lessons in this Japanese behavior which Chinese
and frankly all cross-border investors have looked at and
used to their benefit in this most recent market cycle. By
and large, these investors are not securing loans in one
currency and purchasing investment vehicles denominated
in another currency. As shown in Figure 1, the majority of
loans originated for investments by cross-border investors
have been handled by US based institutions.
Figure 1
Origin of Debt Capital for US CRE Investments by Origin of
Investors 2016 Year Totals
Source: Real Capital Analytics
It is the case the Chinese investors are more apt to use
Asian financial institutions for their investments with 21% of
their US acquisitions in 2016 financed by such institutions.
The European investors are even more pre-disposed to
use debt from organizations headquartered in their home
regions with such debt behind 33% of their activity.
As opposed to the Japanese in the 1980s, these Asian and
European lenders have established operations in the US to
originate mortgages in the US on collateral in place here. In
the current market, Chinese investors are less likely to face
the same currency mismatch, which in turn will prevent the
sort of massive selling of the Japanese in the early 1990s.
The Procyclical Nature of the Housing Boom
In Australia, citizens have, over a number of years now, been
required to put a fixed percentage of their earnings aside
to fund their retirements. The capital built up in these funds
had traditionally been directed by professional managers
but in 2005 a change in the law allowed individuals more
choice in fund allocation and flows to real estate related
vehicles surged.
With favorable exchange rates and a steady source of capital,
Australian investors became one of the leading buyers of
US commercial property in the economic expansion that
accompanied the housing boom. As shown in Figure 2, their
purchases totaled $13.8 b in 2007 alone. Australian investors
were behind $10 b of retail purchases at the time.
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Figure 2
The Sedimentary Layers of Cross Border Capital Focused on
US CRE Investments
Source: Real Capital Analytics
The US / Australia exchange rate moved south, so to speak,
with the US dollar losing 13% of its value relative to the
Australian dollar from 2004 to 2008. The Australian dollar
denominated performance of these funds faltered, even
ahead of the GFC. The extreme negatives experienced by
the retail sector as US consumers pulled back led to even
more pain and individual investors lost faith in these funds
and sold out of their positions.
The lessons from the experience of the Australians is mixed.
Currency regimes do not stay fixed forever. Even if currencies
seem to be trading in a fixed range over time, they can move
suddenly based on changes in growth and productivity
between nations. How investors manage these risks, which
is really beyond their control, is an issue that can turn the
capital spigot off or turn it on full-blast.
The Implications for Chinese and Other Cross-Border
Investors Today
In making the decision to move capital to the US, this
new generation of Chinese and other global investors are
cognizant of the mistakes that others made in the past. Just
because these investors are aware of these mistakes does
not mean that they necessarily will not repeat them. Likewise,
there are a number of lessons that one can take away
External Forces Now and in the Future
The rear-view mirror of the Japanese experience of the
1980s is not that of the Chinese investors active in the US
today. Like the Japanese though, it was changes in market
drivers in China which led capital to flow here. Both cases
involved forces external to the US economy, but these
external forces varied.
As a developing economy, historically there were a number
of barriers in place to prevent sudden capital outflows from
China. As these barriers were eased over time more capital
flowed out of China. First state-owned enterprises, then
developers bringing some of their construction expertise
abroad, then most recently insurance company investors.
From the point of view of a regulator in the US, Chinese
money showed up out of the blue and drove multi-billion
dollar transactions like the purchase of the Waldorf Astoria
hotel in New York. Such transactions where cross-border
CRE Finance World
investors paid top dollar for an asset raises red flags on the
part of regulators in the US as the Japanese did most of
the same sort of thing in the 1980s. The red flag on this
activity comes from the fear that just as the Japanese
capital flowed in and then out so quickly that the Chinese
capital may follow the same path.
The Japanese chased deals in the US simply because it
was a yield opportunity. This movement of capital was truly
hot money in that these investments only made sense due
to interest rate differentials. This Chinese insurance money
came to the US though for a different reason.
Despite the variety of sources of capital from China, what
they had in common was the simple fact that barriers on
capital outflow had left these groups allocated 100% to
Chinese real estate and a need to diversify their holdings.
Figure 3
Chinese Investors Have Bought Different Type of Assets than Other
Cross Border Investors
Source: Real Capital Analytics
Summer 2017 Volume 19 No. 2
What the Chinese investors have been buying also indicates
at least an intention to hold assets here over the longer
term. Looking at all cross-border investment activity in the
US over time, only 5% of capital invested by non-Chinese
investors was tied up in development sites. The Chinese
though have put 12% of their capital in development sites
as the intention is not simply to hold assets for yield but to
build businesses.
Moving forward, capital coming to the US from China may
move in fits and starts. Chinese policy makers have recently
acted to curtail capital outflows to manage the devaluation
of the Yuan in a controlled manner. This pullback has led
to the fear that Chinese investors will disappear from the
North American markets moving forward. A limit on current
outflows of capital from China is not the same thing as
saying that capital will flow backward. Presumably these
limits may be eased in the future as the Yuan/US$ exchange
rate stabilizes at a level that puts no pressure on Chinese
foreign currency reserves.
Another issue to consider here is that as financial markets
liberalize worldwide other countries may suddenly invest
strongly in the US as walls to efficient capital movement
fall. Mexico for instance has been moving to tear down
internal barriers to the efficient operation of the real estate
market with the FIBRA legislation. If external barriers to
this investment were suddenly removed, one might see as
many headlines about Mexican capital investing in the US
with some of the same features of recent coverage of the
Chinese investors.
Do Cross-Border Investors Execute Efficiently?
One significant fear of regulators is that cross-border money
is not expert in local markets. If these investors come into
a market, the fear is that they will naturally overpay, face
performance challenges and flee quickly as expectations
change. Coming in and out so quickly, the fear is that this
cross-border money will destabilize markets. Capital can
flee quickly as expectations change but there are signs to
suggest that this investment quick flow is moderating and
is not as destabilizing as feared.
Looking at the behavior of the Australian money that came
to the US during the housing boom, it was a clear case of a
bandwagon effect. Strong growth in the retail and housing
markets in the US combined with a need to place capital
quickly arguably helped push pricing in the retail market to
unsustainable highs. Had this money been better hedged
against currency swings, the investment opportunity may
not have looked as attractive and many not have grown
as quickly.
Into late 2016, the cost to hedge the US/Euro exchange
rate was growing.2 Conservatively leveraged German
investors pulled back on their investment activity by 17%
in 2016 versus 2015 as a result. Generally speaking, these
investors are not buying currency hedges for individual asset
purchases, instead putting on hedges at the portfolio level
across all asset classes. Still, even at the fund level, too
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much exposure to US $ denominated assets is acting to
curtail German investment at a time when prices are at or
near a cyclic high.
With respect to the Chinese investors active in the US
today, it is generally understood that the Chinese Yuan had
been slightly overvalued until recently and that an ongoing
devaluation was in place. In 2016 as hedging currency risk
became too expensive for German investors they curtailed
property purchases in the US. The Chinese though expanded
their property purchases as these real assets here acted
as a natural hedge on the devaluation risks faced at home.
Investing for capital preservation is not behavior that suggests
a discounted sale in the near term.
More fundamentally however, do these cross-border investors
overpay when they purchase assets in the US. Here the
evidence is mixed. In an examination of cross-border capital
coming to the office market of the US, one study found
that yes, markets with the strongest price increases and
highest absolute price levels had a higher concentration of
cross-border capital.3 However, the authors noted that more
research was needed as the capital may focus on these
markets for other reasons.
A more recent study focused just on the New York office
market does suggest that the causality is all reversed.
Cross-border capital may not be driving prices up in the
largest markets of the US by paying the highest prices, but
instead are paying the lowest cap rates because they are
buying the highest quality assets.4
Conclusion
While the Japanese investors came in so aggressively in
the late 1980s there are indications that they will be coming
back to the US in the near term. After suffering years of low
level returns, Japans Government Pension Investment Fund
(GPIF) announced recently that it is recruiting managers
to deploy capital into real assets.5 Just as there have been
headlines in the business press fretting over the Chinese
investors coming to the US as a sign of a market peak, if
and when the Japanese return in force with investments
in US real estate, these headlines will be more extreme.
CRE Finance World Summer 2017
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Into this market cycle there have been fears expressed that
the inflow of cross border money is a sign of a price bubble.
The rationale after all is that Japanese money flowed into
the US quickly and as it flowed out, this hot money distorted
market activity and amplified price declines.
The motivations of Chinese capital coming to the US in this
cycle are externally driven just as the Japanese investors
were motivated not by forces in the US but by forces in
Japan. These motivations give regulators pause. These
external forces by their very nature are not something that
regulators will have an easy time measuring, managing or
controlling. Still, it is a mistake to view this cross-border
money as unprofessional and price insensitive.
This is not to say that the Japanese, Chinese, Mexican,
whatever capital origins you might imagine will not make
mistakes in this cycle. Ultimately this capital is deployed by
people and people often misjudge opportunities and make
mistakes. However, if these investors make mistakes, they
are going to make their own mistakes.
1 World Bank, Policy Research Working Paper, WPS 1452,
The 1985-1994 Global Real Estate Cycle: Its Causes and
Consequences May 1995, Bertrand Renaud
2 https://www.wsj.com/articles/dollar-hedging-costs-hit-trea-
surys-1473979806
3  Does Foreign Investment Affect US Office Real Estate Prices?
Pat McAllister, Anupam Nanda, The Journal of Portfolio Man-
agement, September 2015.
4 Steven Devany, David Scofield http://www.tandfonline.com/
eprint/Dz2v2ihnB958NygZNk8f/full
5 http://www.reuters.com/article/us-japan-gpif-alternative-
assets-idUSKBN17D0DR
CRE Finance World
The Clock is Ticking for
Commercial Real Estate
Today, the commercial real estate (CRE) world is abuzz as
investors try to understand where we are in the cycle. While
the cyclical nature of CRE is no secret, some investors
are too busy trying to push capital out the door when they
should be understanding the position in the cycle. The clock
is counting down toward the end of the CRE cycle, where
values are not being supported by prices, and investors
need to be particularly conscientious about how they invest
in the capital stack of CRE, what property types are best
suited to this phase and what locations are better positioned
to come out ahead.
We have been climbing a wall of worry for a few years now,
anticipating rising cap rates and downgrades to values.
Even so, deals are getting done but with caution and se-
lectivity. Fewer buyers today are willing to pay steep prices
in certain markets. But make no mistake there is capital
in the market for CRE. One reason this cycle has lasted so
long compared to other cycles is that the lending process
has been more selective, although this has resulted in a
decreasing number of transactions. I, along with the many
investors I talk with every quarter, believe we have entered
the eleventh hour of the real estate cycle (see Exhibit 1
for a graphic representation). The alarm is set to go off at
the peak of the cycle, values compared to prices are flat to
declining, and investors need to be prepared. This article
presents evidence that the economic and CRE recovery is
long in the tooth and discusses the implications for the
CRE industry as a whole.
Exhibit 1
Commercial Real Estate Market Cycle
Summer 2017 Volume 19 No. 2
Ken Riggs, CFA, CRE,
MAI, FRICS, CCIM
President
Situs RERC
Since the bottom of the Great Recession, which is at the
6:00 position of our clock, CRE has experienced a very
nice run-up with few hiccups in the investment market. On
a risk-adjusted basis, many would argue it is the asset class
that has done the best. CRE was an attractive alternative
during the early years of the recovery because it offered a
real/tangible asset class with a strong income component.
In an era when 10-year Treasury rates have been less
than 3% over recent memory, a 5%-plus income return
has been a major strength for the CRE market. When you
include years of double-digit returns, it is easy to sort out
the winners from the losers. The time from the bottom of
the recession to roughly the end of 2015 could be consid-
ered the expansionary phase of the market cycle. 2015 saw
record transaction volumes and, at the time, record prices.
Since 2015, the market has begun to plateau and has
entered into the peak of the cycle from a value versus price
perspective. Many analysts have disagreed about how long
this peak will last, but general sentiment points toward a
downturn in 2018 or 2019.
Since the recovery (and eventual expansion) began in 2009,
real GDP grew by 17%, led by technology, electronics and
health care. Personal income and disposition have grown
almost 4% annually since 2014 (Bureau of Economic
Analysis) and quarterly personal consumption expenditures
(PCE) has been 1.6% or greater since Q1 2014, with
consumer spending increasing every quarter. The consumer
price index (CPI) from March 2016 to February 2017 rose
a steady 2.7%. These macroeconomic indicators suggest
stable growth, yet the market is nervous about the uncertainty
in the world and pausing to ask, How much longer can
this recovery last? Between 1945 and 2009, the average
duration of an expansion cycle in the U.S. was 58.4 months,
according to the National Bureau of Economic Research
(NBER). As of April 2017, we are in the 94th month of
expansion. Headwinds for the economy, such as a graying
American population and slowing aggregate U.S. population
growth, will be trends to watch as the expansion cycle
continues (or ends).
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45
CRE Finance World
The Final Countdown: Nearing the End of the Cycle
from a Value versus Price Perspective
Volume and Prices
CRE deal volume fell to $133 billion in fourth quarter 2016,
down 20% from fourth quarter 2015. The drop in volume
is attributed to a pullback in portfolio and entity-level
transactions, however, not to a lack of demand. The Wall
Street Journal reported that global CRE fund managers had
a record $237 billion available to invest at the end of 2016
compared to $136 billion at the end of 2012. The unspent
amount of the total committed capital, called dry powder,
is at a record high, signifying that the drop in transaction
volume is not explained by a drop in demand. Instead, it
reflects investors caution related to geopolitical events
such as the U.S. election results, Brexit and a series of
European elections this year.
This fall in volume, however, has not corresponded with
falling prices. As of the beginning of 2017, CRE prices have
grown to roughly 23% beyond their pre-recession peak,
according to Moodys/Real Capital Analytics Commercial
Property Price Index. Interest rates are rising and buyers are
concerned about future cap rate movements. On the other
hand, sellers are not willing to match the buyers concerns
because sellers believe the strong demand suggests their
property value can rise even more if they wait.
Total CRE Returns
Probably the most striking evidence of the end of the cycle
is the forecasted trends in CRE returns. CRE enjoyed
double-digit returns from 2010 to 2015, according to the
National Council of Real Estate Fiduciaries (NCREIF). Average
total CRE returns dropped to about 8.00% in 2016; based
on statistical modeling by Situs RERC, total returns are
expected to further decrease to near 6.00% in 2017 and
about 4.40% by 2018 (see Exhibit 2). These expected total
returns are for the base-case scenario. It is important to note
that, while much less likely, the upside scenario forecasts total
returns to go up again. The primary driver of these decreased
returns is the expected decrease in capital appreciation,
which is expected to slow to about 1.00% by the end of
2017 and become negative in 2018 as the cycle matures
and the chance of a CRE market correction increases.
Exhibit 2
Situs RERC Total Return Forecast (20102018)
Note: The Total Return Forecast is Situs RERCs proprietary model based on Situs
RERC data and data from the NCREIF Property Index (NPI) and are for unleveraged,
institutional-grade properties. Total returns are derived from an income component and
a capital appreciation/depreciation component.
Source: Situs RERC, 4Q 2016
CRE Finance World Summer 2017
46
Cap Rates and Yield Rates
According to survey-based research conducted by Situs RERC,
expectations for real estate yields and cap rates continue to
hover around their historic lows as the market appears to be
approaching a turning point in the cycle. For many property
sectors, expected rates have begun to level off. In some
cases, they have started to creep up toward the levels seen
at the peak of the last expansion. Record valuations have
been the primary catalyst for rate compression. With investors
potentially looking to begin taking profits at these high
prices, there might be continued choppiness in rates over
the short term. It is worth noting that within the property
sectors, the apartment sector has begun to see noticeable
increases in required pre-tax yield, going-in and terminal
cap rates, according to Situs RERCs respondents. Situs
RERC survey results have generated mixed sentiment
about the apartment market. Some survey respondents
believe it is still a good investment, citing demographic and
economic trends, while others feel the market is overbuilt
and might soon see a correction. Over the longer term,
Situs RERC expects overall CRE cap rates will begin to rise
as valuations start to fall back to earth. Situs RERCs cap
rate forecast has required rates increasing to about 4.80%
by the end of 2017 and 5.20% by the end of 2019 (see
Exhibit 3). These forecasted cap rates are for the base-
case scenario. Should the economy improve significantly
over the next couple of years, that cap rate compression
could continue.
Exhibit 3
Situs RERC Capitalization Rate Forecast (20102019)
Note: The Capitalization Rate Forecast is Situs RERCs proprietary model based on
Situs RERC data and data from the NCREIF Property Index (NPI) and are for unlever-
aged, institutional-grade properties.
Source: Situs RERC, 4Q 2016
Yield spreads are also signaling the end of the cycle. The
Federal Reserve raised the Federal Funds rate from 0.75%
to 1.00% in March 2017 and indicated that the Fed would
start shrinking its balance sheet this year, which would lead
toward normalizing monetary policy. The CRE industry has
enjoyed historically low interest rates for a long time, which
translated to wider yield spreads. The spread between the
yield (discount rate) and 10-year Treasurys jumped from
390 basis points (bps) at the end of 2007 to 680 bps at the
end of 2012, and the spread at the end of 2016 was 576
bps (see Exhibit 4). Rising interest rates will put pressure
CRE Finance World
on yield spreads and the shrinking spreads might lead to
diminished risk-adjusted returns as the benefits associated
with the relative safety of CRE begin to be overtaken by
other investments. However, rising interest rates also signify
a strong economy, which tends to be associated with a
strong real estate market. The current strength in the
economy is in part fueled by President Trumps promise
to reduce regulations and taxes. If he delivers, it could
encourage more lending.
Exhibit 4
Yield Spreads IRR vs. 10-Year Treasury
Sources: Situs RERC, 4Q 2016
How Is the CRE Cycle Affecting Lending?
The CRE lending environment is facing challenges as
prices peak and competition for deals continues to change
the nature of the market. Strong regulations stemming
from Dodd-Frank and other legislation have made it more
difficult to borrow during this cycle than the previous cycle.
However, the more disciplined approach to lending has
created a less volatile market for CRE, reducing risks for
lenders and potentially staving off a crash. With the tighter
lending standards, some are searching outside of traditional
lenders for access to capital. This has led to the emergence
of dark pools of capital from non-traditional lenders, such
as private equity firms, that have stepped in to provide
capital for deals and taken advantage of the void.
Availability of Capital and Underwriting Standards
According to data collected by Situs RERC, the availability of
capital for both equity and debt investments has generally
trended downward over the past two years, though the
amount of available capital remains above average. This is a
good signal from the market
that pricing and market
We have entered the eleventh cycles are being watched
hour of the real estate cycle. and driving the capital flows
into the market. As shown
in Exhibit 5, the availability
of capital appears to have peaked in second quarter 2014.
At the same time, underwriting standards remain relatively
disciplined, but they are more lenient than those imposed in
the aftermath of the Great Recession. Ratings for underwriting
Summer 2017 Volume 19 No. 2
standards in fourth quarter 2016 were the most conservative
they have been in three years, another indicator that we are
long into the cycle.
Exhibit 5
Situs RERC Historical Availability vs. Underwriting Standards of Capital
Source: Situs RERC, 4Q 2016
Loan-to-value (LTV) Ratios and Commercial
Mortgage-backed Securities (CMBS)
In the debt sphere, LTV ratios have been decreasing since
the immediate aftermath of the Great Recession. This is
particularly true for traditional lenders such as banks, which
are subject to stringent regulatory requirements. In response,
alternative lenders such as shadow banks have stepped in
to fill the capital void, because they are not subject to the
same regulations and are able to take on more risk and
provide loans at higher LTV ratios. Portfolio allocations have
started to shift toward the debt side; investing in debt often
results in better returns and still offers the stability of the CRE
markets cash flow. However, proper CRE debt valuation
procedures are a top concern for investors, particularly
open-ended funds, as the CRE cycle comes to an end from
a value versus price perspective. As investors seek access to
liquidity, mark-to-market valuations which factor in interest
rate changes and collateral-specific risks become more
useful and accurate.
The CMBS market has seen big declines in issuances so
far in 2017. According to Trepp, CMBS issuance fell by 34
percent year-over-year; no deals were issued in January,
and only 15 deals were issued in February and March.
Borrowers have struggled to refinance loans that were
originally issued when the underwriting standards were
not as strict. These pre-crisis loans, known as the wall of
maturities, are still a primary concern for the market. The
risk-retention rules that went into effect in December 2016
and non-competitive pricing have also created headwinds
for the CMBS market. While the overall CMBS market has
declined recently, investors who have stakes in less risky
(i.e., investment-grade) bonds that are toward the top
of the distribution waterfall will be least affected, while
those invested in riskier, subordinated CMBS bonds will
be hardest hit.
CRE Finance World Summer 2017
47
CRE Finance World
While many may believe the CRE market is fast approaching
a downturn, it is worth noting that the market may not
experience a large downturn but rather a slight dip. The
fundamentals underlying CRE, such as unemployment and
job growth, are strong and demand remains high in many
markets. In many ways, the signals may be pointing toward
a soft landing rather than many quarters of decline.
So, what does this all mean? It means the real estate cycle
clock is at 11:45 and the alarm is about to sound for the
end of the cycle (refer to Exhibit 1) as values are coming
under pressure compared to prices. CRE lenders should
keep in mind:
By keeping lending standards tight, lenders might have
learned their lessons from previous cycles and not let
cheap money make the eventual decline of the market
even worse.
CRE Finance World Summer 2017
48
T
 he most important factor for lenders is whether a tenant
can make loan payments. As long as the economy holds
firm and supports CRE tenant revenues, debt payments
can be made, even if property values decrease.
A
 lthough prices have peaked in the market, LTVs have
remained in check and cushions are still favorable. CRE
lending can and will continue to occur.
Y
 es, the CMBS market is slowing, but there is a silver
lining for investment-grade debt.
As values and prices flatten or decline, investors need to
heed the warnings of the end of the cycle and adjust their
investment strategies accordingly. The market has been
bracing for an adjustment, but well find out for sure how
well investors have battened down the hatches to weather
the correction when the clock strikes 12:00.
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